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When feeling good costs you $20,000 (The failure of the Debt Snowball)

A fellow blogger wrote about the debt snowball. For those of you who do not know what the debt snowball is, it’s a method of paying one’s debt off (a good thing) ordered from lowest balance to highest. I wrote about this over 7 years ago when I was Thinking about Dave Ramsey. In that article, I was trying to keep an open mind. I’ll even suggest that for the lost few hundred dollars, if the good feelings you get from knocking off the first card help keep you going, a few hundred, or even a thousand dollars might be a small price to pay for long term success. In my opinion, the fastest way to eliminate all one’s debt is simple – make all minimum payment due, and send any extra money to the highest interest debt. Others insist on the snowball good feelings.

But. As a numbers guy, I ask, “Where do you draw the line?” And toward that end I wrote to Derek, the blogger I mentioned –

“I don’t dispute that killing off a card completely can provide an emotional reward, a boost to one’s feeling of accomplishment, etc. But, I often say “knowledge is power” and one should know the cost of that decision. A few hundred dollars over 4 years? No big deal. Thousands of dollars? Look carefully at the numbers before choosing the method.

Consider – ‘snowballers’ suggest you pay your 8 student loans, all zero interest, $10,000 each, before paying that $20,000 18% card. Of course, that’s an exaggeration, but one that easily illustrates why it’s important to look at the numbers.”

What I expected was an acknowledgement that there are some extreme, contrived, cases when you just pay off that 18% debt first. Nope. His response?

“I used to be like you – a hard-nosed financial professional that only believed in the numbers and percentages. Today, I understand much more about the emotional side of money. If you make no progress over the course of a year, there’s about a 100% chance of giving up. If, however, you pay off a $2,000 loan and get rid of that payment completely, you’ll be charged up and ready to tackle another!

I’d still suggest that people pay off their $10,000 zero interest loan before their $20,000 18% interest loan because there’s a greater percent chance of them getting rid of the smaller debt and continuing their debt payoff journey! Pay a couple thousand extra dollars in interest but paying off the debt is better than trying to save the interest and failing at the debt payoff entirely, don’t you think??”

snowball17

What? I aimed to find the most ridiculous spread from high rate to low, trying to show how there’s some point where it’s silly to pay off your low-to-no interest debt first. And, with a daughter about to enter college, I figured that an example of 8 low rate separate loans was actually possible.  Here’s what this would look like. Do you see what makes this so ridiculous? You graduated college, and the loans happen to be individual loans. The lender could just as easily have made this into one loan with a monthly $664 due. In which case, the snowballers would have no issue paying the “low balance” $20,000 card first. But because these loans are each $10,000, they rise to be the priority, pay them off, get rid of 1, 2, 3, etc as fast as you can, before sending an extra dime to the $20,000 high rate loan.

Let’s look at what happens when we prioritize that awful 18% debt. I happen to choose a total $1,200 available to pay debt, just $236 more than the minimums required. If we pay the low balances first, the interest jumps by over $20,000. A $10K loan is too small to kill in less than a year with only the $236 extra, so the snowball takes 32 months to eliminate one debt,  while my plan gets rid of the credit card 18% debt in 56 months. Would you really be happier paying interest-only for 89 months on that 18% debt but feeling great that you have fewer loans, fewer checks to write?

The truth is that most people are not in such an extreme situation. And the real cost may be far less that this contrived example. As I offered on Derek’s site, knowledge is power. Why would you not wish to know the cost of one method vs another?  And if you knew the cost, how high (or low) would it need to be to sway your approach to paying off your debt? What could you do with the $20,000 you’d have saved over these 10 years? How much snowball Kool-Aid does one have to drink to state they will stick to a method no matter the cost?

By the way, I do believe in more than numbers and percentages. I also believe one shouldn’t fall for bad advice offered by a celebrity, Dave Ramsey, who takes a “my way or the highway” approach to his advice. Know your options, and decide for yourself.

On a final note, as I was writing this, John, another blogger who writes at Military Fire, also visited Derek’s article, and agreed with me, stating,

“If the snowball method costs you “a couple thousand” annually, and you make less than $50K a year, you would have to work 13 months a year to recoup that unnecessary interest. The snowball requires nuance. Lets help people work smarter, not harder.”

Derek, on the other hand, wasn’t budging,

“I’m a nerd just like you and understand the percentages perfectly. After helping hundreds of people though, there’s no denying that those who pay off a debt early are far more likely to stick with their debt snowball. To help the most people possible, I’m sticking with this method for life.”

Check out John’s excellent article Debt Snowball: Not a Chance in Hell, because John doesn’t like throwing away money on interest any more than I do. If you comment at either site, let them know that Joe sent you.

2016 Year End Tax Tips

The end (of 2016) is near. Still, you can do a lot to help your finances before the ball drops on Saturday and we ring in the new year. Let’s look at some of my top year end tips –

  • The Charitable RMD is part of the tax code that allows those who are 70-1/2 and taking RMDs from their IRA to donate directly to a charity. In effect making a donation deductible even though the donor doesn’t itemize.
  • If you are retired already, and are not too close to the next tax bracket consider a Roth conversion to “top off” your current bracket. Say you are at a taxable $65K. You have an additional $9,900 you can withdraw or convert to Roth, and pay just 15%. By converting to Roth, you help to keep from breaking through the 25% rate as your withdrawals increase in the future.
  • Are you getting a big refund (I know, big is relative) every April? Has no one told you that Big Tax Refunds Are Really Bad? Let me be the first.
  • Do you have an FSA (flexible spending account) at work? If there’s a bit of money left, you should consider a quick purchase, typically, eyeglasses come to mind as they are an easy expense, and have a wide range of cost from simple reading glasses at $100 to a fancy pair of glasses well over $500. Don’t let that money get forfeited.
  • Year end is a good time to look at how much you are depositing to your 401(k) account. Can you bump the deduction up by a percent or two? You won’t regret it. Are you at least depositing enough to grab the matching amount? If not, do this now.
  • Did 2016 bring you any change in family members? Marriage, new child, divorce,  family member pass away? It’s time for an annual review of the beneficiaries on all of your accounts. It’s never to soon to see if your new spouse has a former spouse of their own as a beneficiary. Pretty important to get that updated asap.
  • See if the Tax Loss Harvesting can help you. You can read the full article, but the important thing to know now is that you can take stock losses against up to $3000 of ordinary income each year. Hopefully, you are making a profit, but this is an easy way to get a bit of money back on a stock you are holding at a loss and are wanting to sell.
  • Last, it’s not too late to beat the standard deduction. This strategy depends on your current situation, of course. It’s ideal for a couple who just misses the required minimum for itemizing, $12,600 for 2016. Pulling some of these deductions into the current year can allow them to itemize. Check out the article I wrote earlier this month, and see if this strategy can help you.

That’s all for this year, Happy 2017

 

Financial Planning 101 for Young Adults and Why You Need to Pay Attention in Class

A Guest Post today –

You’re young and the world is your oyster; nobody is disputing that. The one mistake that a majority of young adults make, however, is failing to take their finances seriously. You’ve just completed four (or more depending on your major) years of college. During that time, you worked hard to earn your degree, but you also partied hard. It’s time to get serious, because failing to do so will cost you right away and over time.

Why Financial Planning Is So Important

Financial planning might seem like something you needn’t worry about until you are in your 40s or 50s but it’s important now. Your place within the global economy will directly affect your future. It’s never too early to start saving for your retirement, much less plan for unforeseen circumstances. What if you become ill and cannot work? What if something worse happens? You don’t have to be in debt for the first 20 years of your adult life if you plan accordingly.

Some Ways to Put a Financial Plan in Place

As you start your new adult life, you’re already in debt. You have student loans that must be paid off and you have a new form of independence to maintain. You’ve said sayonara to your dorm life and must now pay for your own pad, which will cost you significantly more. Yes, you’re starting out in your new career, but this won’t cover your expenses right away unless you’re extremely lucky and earned a CEO position with a Fortune 500 company upon graduation, which, face it, you didn’t.

The key to financial planning is start working on your budget and savings now. Don’t make the mistake of assuming you have time. The more you plan now, the better off you’ll be later, and your first step is assessing your student loans. How much of your monthly budget are they taking up and is there a way you can refinance them to save you money? If you can refinance them into a lower interest rate, you’ve just added thousands of dollars to your personal finances.

Another thing you should do is set a monthly budget and stick to it. Keep track of how much you spend. This helps you see where there is hemorrhaging, which will enable you to take steps to stop the financial bleeding. For example, are you paying excessively for insurance coverage you don’t need? Do you really know what insurance coverage you need? Enlist the expert guidance of a local insurance agency to see where you can save precious dough.

Avoid Luxury Expenses Until Later

Your college graduation present to yourself should not be a luxury vehicle or downtown pad. You can’t afford it, unless you secured that Fortune 500 management position discussed above. Start off small, because you will have better financial resources to go big later. When just starting out, it does you no good to exceed your financial capabilities, because stretching yourself too thin will land you residency back home with mom and dad.

You don’t want that when you’re proving to them and yourself that you’re a responsible adult now. Take your finances seriously, plan wisely, and reap the benefits in your future. You’ll be glad you did.

Spread Betting as a Money Making Exercise: A Brief Guide

A Guest Post today –

When you think of financial market trending, your mind is almost always invariably drawn to live shares and corporeal assets. From company stocks to commodities such as oil, these physical entities once dominated the market and served as the staple of any successful trading portfolio.

The market has changed considerably over time, however, with diversification having created a host of innovative product derivatives and new methods of training on the financial markets. Take spread betting, for example, which is now a particularly popular trading method and one that has empowered novice investors across the globe.

What is Spread Betting? A Brief Guide

If you are new to the concept of spread betting, it is a derivative trading vehicle that does not deal with live shares. It also does not require traders to own an underlying asset or commodity, affording them flexibility in terms of how and when they are able to generate a profit. Instead, it enables investors to take a position against the value of an underlying financial instrument (and back it to either rise or decline in the prevailing market). This is similar to the concept of standard betting, where customers back one of two potential outcomes relating to a specific asset class.

This is therefore a speculative trading vehicle, and one that offers a clear, competitive advantage to spread-betters. After all, it is possible for traders to profit in a depreciating market through spread betting, as investments do not always require the price of the underlying asset to rise if they are to be successful. If you speculate that the price of a stock or asset will fall, for example, you can make money as the market declines and burden of ownership begins to take its toll on traders.

Interestingly, this method of trading is not restricted to stocks in the modern age, with online brokerage platforms such as ETX Capital offering access to diverse asset classes such as indices, currencies, gold and oil.

The Last Word

In terms of popular application, spread betting as become a preferred trading vehicle in markets such as the foreign exchange. After all, volatile markets of this type are notoriously complex, while only traders with an appetite for risk and a keen sense of determinism are able to prosper. Spread betting simplifies the complexities of this market and minimizes the risk of forex trading, however, so long as you approach the market with some understanding and an ability to analyze real-time trends.

Note: This type of trading is not yet approved in the US, but I have a worldwide audience, many of whom are interested in CFD (contract for difference) and spread betting.

The Standard Deduction and How to Beat it

Last time, we talked about the potential new tax rates. Much of my concern focussed on the standard deduction, which looks to rise quite a bit at the peril of personal exemptions. schedulea

But, as I hinted, there are opportunities to shift things around to our advantage. Let’s look at Schedule A (you can click the image to view it regular size). It starts with medical deductions. When working, our insurance premiums were deducted pre-tax, so this line never really mattered much. Now, the full tab is our cost and it’s above 10% of our income, but it occurred to me – why lose that 10% every year? Say the insurance cost is $10,000, but only $5,000 can be deducted. By paying the full 2017 premium before the end of this year, the entire insurance bill can be added to the Schedule A. This results in $2500 saved tax for paying the 2017 insurance an average of 6 months early. Think on this, it’s not paying a year early, since the payments aren’t due next December, they are due each month. The return on that $10,000 is actually close to 50%.

The same strategy can be applied to property taxes. Even if the bill for the second half of next year hasn’t been issued yet, the town is probably happy to take your money early. Depending on the size and cost of your house, this can be $4,000-$10,000 (or more), in a deduction pulled into this year.

The third, and last, deduction I’ll mention is charitable contributions. Schwab, Vanguard, and Fidelity all offer a way to make your donation and deduct it this year, but disburse it to charities at a future time. This is a great way to consistently support your favorite charities, while maximizing your tax saving.

If the new tax code passes, and you had $25,000 or so in itemized deductions, this strategy might help you group your deductions so that the $50,000 2 year total is split to $45,000 in odd years and $5,000 in even years. In other words, you take the $30,000 standard deduction one year, but pull in all you can to take $45,000 the next year. That’s nearly a $4,000 benefit by juggling the timing a bit.

Keep in mind, I wrote this with my thoughts toward the new tax code, but this strategy can help people now. A couple who looks at their tax return and realizes they have just $12,000 in itemized deduction, vs the standard deduction of $12,600, can use this method of pulling in deductions from 2017. I know that I’ll be writing a check next week for our entire 2017 medical insurance premium.

Let me know if this strategy is something that can save you some money on your taxes. More year end tax thoughts coming.

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