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A friend of mine works in the finance industry and teaches a financial literacy course for the church that he attends. I decided to attend the class with my wife. I went partly because I just enjoy listening and talking about personal finance (surprise surprise!), but also because I wanted my wife to go to the class. Unlike me, she isn’t all that interested in personal finance topics. She only reads my riveting personal finance posts when I ask her too!
One of the topics taught at the class was about paying down debt, and my friend advocated Dave Ramsey’s “snowball” method. Basically with this approach, you pay the account with the lowest balance first and then move on to the next one. At the end of the class, I talked to my friend and said that I did not agree with the snowball method. I said that the math doesn’t make sense and that you should pay the account with the highest interest rate first to save on the interest you pay. My friend told me that while math may be on my side, his experience told him that paying off small balances motivated people to continue on the path to debt freedom.
After this conversation, I came to the realization that math and logic does not always work in personal finance. Of course personal finance is personal and it depends on the person. For better or worse, I think of myself as someone who bases most of my decisions on logic. While I might think I base my decisions on logic, nobody is a robot. As human beings, we have complex emotions and we use both reason and feelings in our thought process when we make decisions.
Laurie The Frugal Farmer said,
“What matters most about a debt payoff plan is whether or not it will allow you to stick with it through to the end”
We need to be motivated. We need to be inspired. We need that so we stay disciplined and committed to our financial goals. That’s why there are so many personal finance articles teaching you to trick yourself to save more money or to trick yourself to spend less money.
One thing that I never really understood was the concept of “forced savings.” I’ve always been a saver and never felt the need to be forced into doing it, but for some people, they may need it.
Buying a house
I know a high-earning couple who accumulated a good amount of debt, including both student loans and consumer loans. They can’t seem to save much, yet decided to buy a house recently. One of the reasons cited was that it would force them to save. I think that for people who are not ready financially to buy a house, it is often better to rent and save up a down payment as well as fix up your finances before buying. Renting is usually cheaper than buying, and you can use the savings to help fund a down payment. That sounds good in theory, but do most renters really save the difference?
Megan McArdle from Bloomberg View said,
“[P]ersonal finance really isn’t about math; it’s about discipline. And homeownership, whatever its drawbacks, does force people to save, even if the rate of return on those savings is low.”
Buying whole life insurance
I’m not a big fan of buying whole life insurance. I’m in the camp that believes the mantra “Buy term and invest the rest.” I think that you’d be financially better off doing that. Once again, the same high-earning couple I know were looking into life insurance, and they chose whole life insurance. When they told me the arguments for buying it which they parroted from the insurance agent financial advisor, I just shook my head (figuratively). Specifically, they touted the investment portion of whole life insurance. While I think there is a place for life insurance in estate planning and certain tax circumstances, I don’t think it’s the right financial choice for most people because of the higher premiums, fees and lack of transparency. But maybe I’m wrong? While I might buy term and invest the rest, is someone who needs to be “forced” into saving really going to do that?
Large Tax Refund
Not to pick on this high-earning couple, but another method they use to force themselves to save is to claim “0” exemptions on their W-4. One reason is because they are deathly afraid of owing taxes. This really shouldn’t be a fear because they get a substantial tax refund each year. The other reason is because they like getting a big refund. Someone who is financially savvy would not like this method to save money because you’re basically giving the IRS an interest free loan for the year. The better method would be to claim the proper amount of exemptions and automate your savings throughout the year. But once again, are those who are bad at saving really going to save or would they be better off keeping their spendy hands off of the money? Honestly, I have to admit that while I know that a small tax refund means I did a good job putting money in my pocket throughout the year, I really like getting a big refund! Argh! I think my emotions are getting the best of me!
Now I’m not advocating for people to buy a house when they’re not ready, to buy whole life insurance rather than term life insurance, or to claim “0” exemptions. I just don’t want to be someone who thinks that there is only one right way to do things when it comes to personal finance. What works for me, might not work for others. I can get on my soap box and argue why my method of saving is better mathematically until I’m blue in the face, but if others aren’t inspired or motivated to follow, what good is it?
Do you lean more towards emotion or logic when making financial decisions? Do you have to trick or force yourself to save money?
I think I am somewhere in between. I like the avalanche method because the numbers make sense, but it’s also easy for me to say because I only have two student loans. I can see how the snowball method would be useful for those needing some motivation. I also like getting a tax return. I know a lot of bloggers advocate against it, but it’s nice to look forward to. A lump sum check has a greater impact. I’ve always been a natural saver, too, so forced savings is a bit of an enigma for me.
I’m with you…but some people are just not numbers people and need the motivation. We natural savers don’t really require forced savings, but I think for others, it is necessary.
I’m more of an emotional guy. I tried the “avalanche” method to no avail, but the “snowball” method worked perfectly for me. I guess that little boost I got kept me going. I also like to receive a tax refund. I know it doesn’t make sense – logic tells me so – but what can I say, it makes me feel good.
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Very good question, and one I’d have to give some deep thought to, but overall I’m going to guess I’m a little bit of both. I think both with my head and heart…and usually one is speaking louder than the other. Very good question though…
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I used to get huge tax refunds. I know about giving the government tax free money etc..etc..but l cared about was the forced savings. It had a specific purpose, to pay off taxes on our properties. It was nice to know l wouldn’t have to dip into savings to pay the huge chunk of change. I didn’t feel it because l didn’t see it.
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Man, I just had to smack my head at the WL insurance bit…but that’s just me. 🙂 Anyway, good post Andrew and I could not agree more that PF is personal. Yes, there are some basic truisms, but so much of it comes down to you and your given predicament as life doesn’t always give us cookie cutter situations. I tend to be a little more on the logic side of things, but know that emotion plays a role as well so I’m likely somewhere near the middle.
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Finances is fueled by emotions I feel. What logic is involved when people all the time, spend more than they earn. (None) I favor the snowball method, because it keeps you motivated, and it provides a boost by rolling over the cash from the past paid off debt to the next debt. The secret to paying off debt is sending BIG PAYMENTS CONSISTENTLY. Oh By the way the high earning couple looks like a train wreck waiting to happen, good luck to them.
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To me, this is why personal finance is so exciting….behavior. While I’ve heard some bloggers complain that there’s nothing to write about in finance, I completely disagree. There’s a world of people screwing up everything because of emotion.
I was a financial advisor for a long time and I STILL have to trick myself into saving. I’ll hide money from myself. I’ll make it hard to get spending money…..anything I can do to keep cash out of my hand.
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I think the emotional part has definitely played a role in our decisions in the past. We prepay our mortgage, for instance, even thought it is at an incredibly low rate. I agree with Laurie from Frugal Farmer on this one. Everyone has to do what keeps them motivated and helps them achieve their goals.
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Emotions caused my money problems, so I use logic now. It is easier to deal with for me and math doesn’t lie. Emotions can be dangerous in personal finance. I can attest to that!
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As a financial planner, I use more psychology to help my clients than numbers and logic. I usually try to “argue” the mathematically appropriate solution to a problem they are having and after a few rounds, I realize that it is a fruitless effort and that they have to come up with the solution that best motivates them to make the changes they need to make. I don’t think I have ever given or worked the same plan twice with any two clients because they are all unique and all have different quirks. It’s part of what makes my job both fun and frustrating. 🙂
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I’m much more of a logical person. Regardless of what advice people dish out, I typically run the numbers before choosing any course of action. For example, I’d rather work towards paying down high interest debt than low interest debt, regardless of the balance of either loan. So the snowball method is not something I personally would do.
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I’m much more logical about my finances but I still pay myself first and trick myself by transferring excessive funds out of my checking. I’ve found that when I have too high a balance I tend to overspend as it’s only a few dollars. There’s a whole lot more which isn’t always the smartest thing.
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I personally wouldn’t buy a house without a robust savings account in addition to a down payment, but I totally write 0 on my W4s. And I’m pretty decent at savings! I know my logic in this case is horrible, but it’s one of the few situations where I let my emotions win out.
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Yea, it’s definitely risky to buy a house when you’re not financially ready. It seems like that big tax return is something many people let emotions win out rather than the numbers!
I thiknk we are a mix of logic and emotion. As a tax accountant I despise big refunds for the very reason you discussed. We also do not use the snowball method. I can’t say that all of our decisions have been driven by logic however. Ruby, our dog provides my husband and I with great happiness but she is one of the most expensive aspects of our life! I think it is a balancing act really.
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Oh yes, as a tax accountant, I can understand why…and while in theory I know it’s not a good thing, I can’t help but be happy when I’m getting a good amount of money back! If Ruby provides you guys with great happiness then it’s worth it!
During the course of our lives, we are subject to a wide variety of advice, strategies and product when it comes to personal finance from many different people. Attorneys, accountants, insurance agents, financial planners, benefit managers, bankers, friends and even uncle Bob at the annual family barbecue!
Ask yourself a simple question, “When was the last time all these people got into the same room with you at the same time for the sole purpose of making your world a better place?” The answer is usually “never”. Therefore, too many people are left with multiple opinions and perspectives resulting in biased information and no strategic coordination. Each piece of advice may, in fact, have a negating effect on another for surely they all ultimately interact as a financial composite. The potential loss to the client via opportunity cost from asynchronous advice, product and strategies may make a larger difference in their financial picture than the fees or costs associated with any one decision.
Everyone has an opinion and they’re usually not afraid to share it. You just have to take everyone’s opinion with a grain of salt and do your own due diligence to figure what you think will work for your own personal financial situation. Thanks for your comment Brian.
Another awesome post, Andrew, and thanks too for the mention. When it comes to finances, emotions, for many people, play a huge part. When we first started our debt payoff plan, we were doing the snowball, but once I started calculating the interest we were paying each month, the math really got to me. It took a few months to do this, but I learned to push my emotions aside and focus on the math. Discipline totally involves your emotions. Most of the decisions we make arise out of emotion, but if we can learn to control and dominate our emotions, we can learn to discipline ourselves in the areas of finance and everything else. But for those who don’t know how to or are unwilling to learn to dominate their emotions (and this can be VERY difficult, so I’m not blaming them), I think forced savings plans such as a house can be a good idea. However, if your friends continue to not discipline themselves, they could easily end up upside-down on that house through the path of a second mortgage and/or another housing value plunge. Then “the last state of that man would be worst than the first.”
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Math doesn’t lie…glad you were able to push your emotions aside. I think once you’re motivated and have gotten the ball rolling, the emotional side of debt payment can more easily be pushed aside. Debt payment and being frugal is often about discipline. And I agree with you that it can be very difficult to focus on the math while pushing aside emotions…I’m hoping my friends will eventually see the light.
Great, thought-provoking post, Andrew! I think a lot of my past troubles stemmed from a lot of emotional spending and mistakes, so it’s easier to rule finances with logic. It doesn’t always work – I have setbacks for sure – but for the most part logic helps me move forward as opposed to hindering me from my long-term goals. I also need to ‘force’ myself to save, as well – it doesn’t come second nature to me, maybe because it wasn’t instilled in me, so I hope to truly instill it into my future kids!
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Thanks Anna! It’s understandable that emotions come into play when it comes to spending and finances…we are human after all. It’s fine that you need to be “forced” to save…whatever works!
I think one of the biggest things in personal finance is knowing yourself and choosing the best strategy based on that. For me, logic always prevails, but I know for others, the emotions can be much more powerful.
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I’m a logical person as well, but I can now understand that not everyone is wired that way so you’re right…you have to choose the best strategy that fits YOU.
Research has established that financial decisions are far more often made by “intuition” than by rational processes; the field of behavioral economics is based on this research. Daniel Kahneman is one of the most important researchers and wrote Thinking, Fast and Slow in 2011 for a general audience. I recommend it highly, and it is widely available.
Interesting, thanks for sharing Carol. I will definitely check that out. I think even for those who say they make financial decisions based on logic (like me)…we underestimate the emotions/intuition that also go into our decisions.
I personally am a logical thinker, I took a lot of math classes in college and I know which numbers come out ahead. But at the same time I think personal finance is personal.
I know how I think, I can look 10 years down the road. When you look that far the road seems impossibly long, some people see that road and decide not to even take it, that’s why they only look 4 months ahead. If they have knocked something out after a shorter period of time they feel like they are making progress.
The long road seems harder, and it may seem harder to make any progress on it, but I think that once you start to notice the progress down that path you will be surprised at how much work you have done and that will be it’s own motivation.
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Absolutely right…personal finance is PERSONAL! And great point, I definitely think once you get the ball rolling and you’ve progressed down the path it makes it easier and you won’t need the emotional tricks to keep you motivated.
Listening or reading the news from foreign media, it is really surprising to find out the sort of debts individuals owe but as to what cost that I simply can’t tell.
Maybe it is a great thing the credit system isn’t all that effective here in Africa because carrying physical $2,000 cash to buy something will of course make one wonder and think properly before the purchase unlike buying through a credit card system.
Here in Ghana, it is the debit card system that works so no interest rate doubling at the end. It is directly linked to your bank account and you can’t spend beyond what is in your bank account.
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Oh that true…carrying physical cash definitely makes you think twice before you buy. Debit cards are good…no need to carry $2000 in cash. I like credit cards, but for some people, it is a temptation to spend more than they have that is very dangerous.
You bring up many great points, where it is with how you pay off debt or how you are setting yourself up to save. While the path might be the most optimal if the path is completed rather than quit, it then becomes the most optimal for that person.
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Exactly…even if the path is the most optimal…it won’t matter if the person ends up quitting.
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I don’t think there’s a ‘one measure for all’ solution either. Some are more emotional, some can do the ‘math’, what matters is to find the best formula for YOURSELF and stick with it.
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That’s the general consensus…do what works for you. It’s not one size fits all.
Yikes… it’s one thing to say that the smallest-balance-first method is a good way to get yourself to stick to a plan, it’s another to present it as the only option, when it has so many obvious (to those of us who care) flaws.
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Yea I think it’s best to present more than one option as everyone is different.
I started with the snowball method, because that was the first thing I had really heard, and it seemed to pop up everywhere I looked, but we had a lot of credit cards with similar balances, so we were able to attack the higher interest rates first. But I agree with you completely. I actually named my blog “impersonal finance” because I thought everyone could be rich if there were able to act rationally and logically. I still think that, but I’ve learned that, even for myself, emotion should, and does, play a large role in personal money decisions.
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I remember when you explained the name of your blog…as ration and logical and we may be…emotions do play a large role in our financial decisions.
I recently went through a similar dilemma when trying to decide if we ought to overpay the mortgage. Financially it might make more sense to invest the spare cash instead, however emotionally the knowledge and security of having a mortgage paid off early is worth more to me than the potential investment gains difference. It will be different for everyone and is very much dependent on their attitude to risks.
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