It’s been several months since I’ve listened to the Dave Ramsey show. However, yesterday I decided it was time to get some post ideas as Dave seems to be a great resource for just that.
A caller said they were getting a $70,000 inheritance and they were wondering how they should use it. They have about $100,000 in debt.
The caller wanted to invest some of the money, and Dave correctly suggested that she should not invest until she has all her debts paid off. Yes, setting up a debt snowball repayment plan is a great idea, but when you have a lump sum, I’d suggest a different way to pay off your debts.
How Should You Apply A Lump Sum To Debt Repayment?
If you receive a lump sum of money, you should list all your debts and pay off either one of the two following debts:
- The debt with the highest interest rate – this will result in the biggest dollar savings.
- The debt that you most regret having – this will result in the highest emotional pay off.
In my case, I hate paying interest so they would be the same debt, and I’d apply the lump sum to the balance with the highest interest rates first. Sometimes we need to take advantage of both the math and emotional benefit when paying off debt. For example, when it comes to balance transfers or credit card consolidation, what if you can continue to aggressively pay off credit card debt and keep emotionally motivated? Then that should be your aim.
3 Reasons To Pay the Highest Interest Rate With A Lump Sum
1. You get a better math benefit when you don’t use the debt snowball.
When you pay off higher interest debts first, you save money in the long term. Holding on to a loan with a 7% interest rate and paying off a 14% loan can literally save you thousands of dollars over a few years. The thing I like about math is that it is pretty much non-negotiable. Fact: Paying off debt at a higher interest rate saves more money.
2. You get an equal emotional reward when you don’t use the debt snowball.
If you get $70,000 and knock off a $70,000 loan, that is going to feel emotionally invigorating. You just went from $100,000 in debt to $30,000 in debt and that is nothing to scoff at. Now, perhaps for the first time ever, you can see the light at the end of the tunnel. You can actually taste what it may be like to be debt free.
If you pay off one debt for $70,000 or five at $70,000, I think you have an equal emotional payoff.
3. When you don’t use the debt snowball, you still have some small loan balances to motivate you to pay off your debt.
This is the biggest reason why you shouldn’t use a lump sum payment in a debt snowball.
With the debt snowball, you intentionally leave your biggest balance last. So you use your $70,000 and get rid of all your little loans, and all is left is one loan for $30,000. You’ll now work away for months or years on one debt. You get no more adrenaline to motivate you. You get no more victories. Just hard work.
However, if you actually pay off your biggest debt and leave your smaller ones, you might have 5 loans totaling $30,000. In that same time period, (months-years) each time you pay off another debt you will actually get more emotional rewards along the way. You’ll even get to feel like you are getting closer to your goal each time a debt drops off your list and each time you add more money to your debt snowball.
If you are currently trying to get out of debt, the debt snowball is a great tool to use. However, if you are currently trying to get out of debt and come into some unexpected income, you might want to pause and consider using that money in a way that is going to either (1) have the biggest math payoff with an equal emotional reward, or (2) leave the most potential of motivation in your future.
Would you suggest using a lump sum in the debt snowball or outside of the debt snowball? Why?
Photo by House of Sims.
{ 6 comments… read them below or add one }
In my brain, I agree with everything you said. In my heart, I disagree.
As Dave Ramsey says, personal finance is – personal. Paying off smaller debts is emotionally ASTOUNDING. It’s like losing the first 10 pounds on a diet. You actually ACCOMPLISH something.
If you pay off $70,000 of a $100,000 loan, you’re still left with the same payments on everything else. If you pay off smaller loans, you gain flexibility.
Also, your example shows 7% and 14% loans. Why wouldn’t you renegotiate the rates to something lower? Surf the debts to something better? I’d like to see a real life example where the difference is substantial. In most cases, people wouldn’t have that variance in interest rates on their debts. Saving 1% or 2% for a couple of years, won’t make that much difference.
Wasn’t really on board with you until your point #3 … that actually makes a lot of sense as struggling to pay of $30K with no end in sight is definitely demotivating! If that same debt is split in multiple smaller increments it will assuredly feel more achievable.
One important caveat to point #1: That “fact” you mention assumes a similar principal amount on the debt. I.e. if I have a $10,000 loan at 14% and a $10,000 loan at 7%, of course I should prioritize paying of the 14% loan. But if I have a $10 loan at 14% and a $10,000 loan at 7%, I’m going to pay a lot more interest on that 7% loan than I would on the 14% loan within a given time frame, just because of the principal. It’s an extreme example, but, given the reality that multiple debts are often quite varied in principal amount as well as interest rate, there is a point at which the actual numbers have to be assessed in order to develop the best strategy.
Employing any strategy other than paying off the debts in descending order of interest rate is only going to lengthen the pain.
It’s this pseudo-mathematical rationalization gets people in debt trouble in the first place. Math is all that matters here: emotions are irrelevant. Save your emotions for your relationships with living beings. (Unless you can find a creditor who’s willing to accept feelings in lieu of dollars.) The idea isn’t to accomplish intermediate psychological goals: the idea is to pay off your debt as quickly as possible. But, people figure they can’t possibly pay their entire debt overnight, ergo it doesn’t really matter whether it takes, say, 7 years vs. 6 years and 3 months. But of course it makes a difference.
I’m sure Dave Ramsey’s a pleasant fellow, but the debt snowball is a bad idea regardless of how good it makes the practitioner feel. It makes no sense to get excited about eliminating small debts along the way, instead of regarding all your debt as one entity to take down as a whole, incrementally. It’s the equivalent of being excited that you now have ten bills in your wallet instead of four, even though the current bills are all singles and the previous ones were fives.
@ Randy
2% interest on $30,000 for two years is close to $1200. I think that is significant enough for consideration. Although really any plan you can stick with is a good one.
Minda, you’re correct that 2% interest on $30k for 2 years is close to $1200, however, this ignores making payments on that $30k. If you use standard amortization to pay off that $30k over 2 years, the interest at 2% is only about $628.
The other factor being ignored is what Ramsey calls “gazelle” intensity. Once you pay off one debt, you get more excited and speed up the payments on the next. You end up making debt payment a goal and any “found” money goes to debt payment. If you only have one debt outstanding, you’re more likely to do this. If you have two, you’re more likely to splurge with found money.