Confusion with Optimal Personal Finance Strategies

I consider myself financially savvy. I participate in the company 401(k) plan with match, max out my Roth IRA, saved well over six months of emergency living expenses, and have no credit card debt. I have a car loan and student loans and rent (because housing prices are too expensive in California).

However, over the past few weeks, I’ve been listening to the Dave Ramsey radio show on XM on the commute home and have been questioning my personal finance strategies. Dave’s strategies include a seven step process to financial peace:

  1. $1,000 to start an Emergency Fund
  2. Pay off all debt using the Debt Snowball
  3. 3 to 6 months of expenses in savings
  4. Invest 15% of household income into Roth IRAs and pre-tax retirement
  5. College funding for children
  6. Pay off home early
  7. Build wealth and give!

From the few weeks I’ve spent listening to his radio show, I’ve determined that his foundation is to eliminate all forms of financial leverage, or simply, debt. Being a trained economist and avid reader of business and personal finance books, I’ve been led to believe that debt is a powerful tool for using “other people’s money” (OPM) to achieve one’s goals. To pay for college, I took out a few low interest loans. To buy my car, I took out a bank loan. To pay for daily expenses, I paid with credit cards (and paid the balance off monthly).

While in theory, using debt can be advantageous, particularly if you can borrow at an interest rate lower than what you can earn investing the money, it doesn’t factor in the human component and risk. Debt is inherently risky, hence the need to apply interest rates depending on the risk levels. If these large multi-national firms, such as Bear Sterns and Fannie Mae and Freddie Mac, are going under due to poor debt and risk management, what makes you believe you can do better without an army of accountants and lawyers on your side.

If you have to take a loan to buy something, you can’t afford it

Car Loan – It does not make sense to use debt to pay for a depreciating asset. In other words, you are paying the bank or the car dealer, for a car that loses value year-over-year. After I pay off my loan, I’m keeping the car forever. Paying $400 to fix a radiator is always a better choice than paying $20,000 for a new car to replace the junker. Keeping your current car is always a smarter choice than buying the latest hybrid to save on gas prices.

Student Loans – While most financial planners and schools say that student loans is an investment in your future, it is only so if you are in a field that can generate a positive rate of return. If you have to take out massive loans to attend a private school and cannot get enough scholarships, then you can’t afford it. I wish someone told me this before I took out my loans. Instead, I’m paying monthly payments for the next 10 years.

Mortgage – Everywhere I read and everyone always says that your house is the best investment you can make. Is it true, or is the housing industry that powerful, like DeBeers with the diamond industry? People say that buying a home is a good choice because you get to write off the tax.

Let’s say you pay $10,000 per year in interest payments to the bank (which is realistic during the first years of the mortgage). Additionally, assume you make $70,000 annually. If you use the tax write off, you would pay taxes on $60,000 of your earnings ($70,000 less $10,000). At the marginal tax rate of 25%, you would “save” $2,500. Put it another way, you paid $10,000 to a financial institution to save $2,500.

Sure, the “housing prices always go up.” During this mortgage crisis, a lot of people are finding out that housing is like an investment. It goes up and down. Unlike stocks, you cannot buy and sell as easily. The transaction costs (broker, agent, closing costs) wipe out any profits and add to loses.

Having no debt is a great way to become wealthy

While economically, it makes sense to keep debt that is low interest, such as a low interest student loan or a 0% interest credit card, emotionally, it does not. From month to month, those debt payments are painful. It gives you a sense of poverty or that you’re enslaved to the creditors. As such, you spend more to feel better and save less because you feel like you have less.

In step 2, “pay off all debt using the snow ball method,” Dave recommends writing down all loans and arrange in order of smallest balance to largest. Pay the minimum balance on all loans, and pay as much as you possibly can on the smallest debt. Once the smallest debt is paid off, start paying the next one, and so on. Using this technique, you get “small wins” and feel like you’re making progress in eliminating debt.

Furthermore, Dave recommends really attacking the debt. He says that you should live on rice and beans, and consider taking on a second job to generate more income.

So what’s the right answer?

 Having spent a good part of a summer sitting at Barnes and Noble’s business section and reading all types of personal finance and investment books, I am now officially confused. What’s the right answer? Mathematically, I know what the right answer is. Add in the human factor, and the equation gets really confusing.


Published by Daniel Hoang

Daniel Hoang is a visual leader, storyteller, and creative thinker. As an experienced management consultant, he believes in a big picture approach that includes strong project leadership, creative methods, change management, and strategic visioning. He uses a range of visual tools to communicate business challenges, solutions, and goals. His change strategy is to build "tribes" of supporters and evangelists to drive change in culture and organization. Daniel is an avid technologist and futurist and early adopter.

4 thoughts on “Confusion with Optimal Personal Finance Strategies

  1. I have used the snowball method and it worked for me, but I know that it doesn't for all. I think that have some debt is okay, as long as it isn't out of control. For example being in college and spending 'future income' in terms of credit cards and student loans. One could work two jobs on top or school or work the debt down, but at the cost of grades and overall well being. What's the point in having no debt and being wealthy if you have no social life. Its about finding balance, if possible.

  2. Hi, Daniel: The two statements you put in large text are key, I think. And it's good to remember there is more than one kind of wealth. For instance, if we have freed ourselves from the mental stresses associated with acquiring and then clearing our debt (over and over again) then we're able to enjoy doing what we truly want to do. We do work we love (fostering financial gain in the process), we stop wanting all the new things "the Joneses" just got, and we put more time into our social lives. All's good. So now I'm back to your two key statements. Thanks for the solid reminder! 🙂

  3. @ Jessica – Thanks Jessica. The problem with having such a great social life, and not conservative with debt is that eventually, your debt will be so great that all your money goes to debt, rather than the pleasures of life. Debt free and social fun are not mutually exclusive. However, your point is well taken. I'm going out for a nice dinner now.

    @ Julie – I actually am paying off a car loan and some student loans right now, as well as saving for a huge down payment for my first home. Like my comments to Jessica above, being debt free doesn't mean you can't have fun.

  4. Daniel and I share the same confusion on this matter. Throughout my young life I was always taught to avoid risky debt at all costs, and with the current fiscal situation in this country, I am frankly embarrassed.

    During the housing boom a lot of wealth was created in the U.S., but now that wealth has been transfered three to four times over. If we also consider the U.S. national debt of 9.76 Trillion (That's a "T" PEOPLE!) We are entering a serious tipping point for the history of our world dominance.

    I am so fortunate to have so little debt, my current truck loan of $7500 at 4.25% fixed. I owe no monetary debts for school, credit cards, or housing, and have been able to put away 20% of my salary into retirement vehicles over the past few years without having to pay down interest and maintenance costs for real estate. Certainly I cannot call myself a home owner, but with the sky high prices in California I think I'll ride this one out and still come out on top.

    So Daniel, all we have to do is convince people that a FICO score above 700 is ultra rare, but ULTRA SEXY!

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