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Financial Peace University Lesson 4 – Dumping Debt
Beaking the Chains of Debt
I mentioned in the previous FPU post that Dave Ramsey is very big on creating and using a cash flow plan each month. I now have to say this week that he stresses even more the importance of getting out of and staying out of debt. I would probably say that this is the most important facet of his financial peace plan.
If you tell a lie often enough, loud enough, and long enough, it becomes accepted as truth
Ramsey spends the majority of this session presenting and debunking various myths about money and debt – some that I found very interesting. I’m not going to go through every myth in this post – I’ll just hit some I found more intriguing (I have to leave something for you when you actually take the course, right?).
Myth: Playing the lottery and other forms of gambling will make me rich.
Truth: Playing the lottery is a tax on the poor and on people who can’t do math. Ramsey asked this question, “Why is the lottery line not filled with rich people?” and also presented this telling statistic: People with no high-school diploma spend on average $173/month on the lottery while people with a college degree spend an average of $49/month. Do you know how much money $173 will grow to over time if you invested that money each month instead of wasting it on lottery tickets?
Myth: Car payments are a way of life and you’ll always have one
Truth: Staying away from car payments by driving reliable used cars is what the typical millionaire does. I admit that I totally bought into this myth; I simply did not see a way that you could drive a decent car without having payments every month. We used to pay $800/month on our two cars. You know, you can do a lot with $800 if you don’t have to give it away each month. We’re saving a lot more money these days since we accelerated and paid off our car loans. In fact, Ramsey states that the average car payment is $464/month and if you invested this amount at a 12% interest rate starting when you are 30, when you reach age 70 you will have $5.5 Million. Wow, I hope getting a nice, new car every few years is worth $5 M to you!
Myth: Leasing your car is what sophisticated financial people do. You should always lease things that go down in value.
Truth: The car lease is the most expensive way to finance and operate a vehicle. I remember reading reading an article in Consumer Reports about this exact topic. In fact, I found these statistics that Ramsey offered very enlightening: If you buy a new car with cash, the dealership makes an average profit of $82. If you finance that new car through them, the dealership makes an average profit of $775. If you lease that new car, the dealership makes an average profit of $1300!
Myth: I’ll take out a 30-year mortgage and pay extra. I promise!
Truth: Life happens! Something else will always seem more important, so almost no one pays extra every month. Never take more than a 15-year fixed-rate mortgage and your payment should be less that 25% of your take home pay. It is true that using a 15-year mortgage will save you tons of interest! In fact, on a $225,000 mortgage at 6% interest, you will save more than $143,000 in interest with a 15-year mortgage compared to a 30-year mortgage.
This is a hard one to do though. When we bought our current house, we didn’t buy one anywhere near what we were qualified for, but we are barely below the 25% of our take home pay and that is on a 30-year mortgage! Interestingly, this advice is the opposite of what Crown Financial Ministries will tell you to do. They suggest paying extra on a fixed 30-year mortgage to make sure you can still afford the payments even if something changes in your financial situation (of course, that’s probably why Ramsey tells you to keep the payment below 25% of your take-home pay).
Myth: It is wise to take out an adjustable-rate or balloon mortgage if “I know I’ll be moving.”
Truth: You will be moving when they foreclose! Remember, an adjustable rate mortgage transfers the interest rate risk from the bank to you. They are good for the bank, not for you. (Disclosure: we currently have a seven-year adjustable rate mortgage).
Myth: You need a credit card to rent a car or to make purchases online or by phone.
Truth: A debit card will do all of that, except for a few major rental companies (check in advance). Remember that you get the same level of protection as a credit card when you swipe your debit card like you would for a credit card (not when you enter your PIN number).
Myth: “I pay my credit card off every month with no annual fee. I get brownie points, air miles, and a free hat.”
Truth: A Dun and Bradstreet study found that when you use plastic instead of cash you spend 12-18% more because spending cash hurts. So what if you get 1% back! I am currently struggling with this actually. We typically use credit cards for most of our purchases but I am really re-evaluating this strategy as we go through this class. I hope to start moving to cash or debit card for some purchases next month as a trial to see if we spend less and if we can do a better job tracking it as we move through the month.
Myth: I’ll make sure my teenager gets a credit card so he/she can learn to be responsible with money.
Truth: Teens a huge target of credit card companies today. This is chilling: more young adults filed bankruptcy last year than graduated from college.
Myth: Debt is a tool and should be used to create prosperity.
Truth: The borrower is slave to the lender. In a survey, the Forbes 400 were asked, “What is the most important key to building wealth?” 75% responded that becoming and staying debt free was the number one key. Think of it this way, your largest wealth building tool is your income so don’t waste it on interest payments each month. Now think about this: How much money could you save, invest, blow, and give away if you had no debt payments each month?
Steps Out of Debt
Getting out of debt is hard and you have to be focused and serious about it to get it done. “You can wander into debt but you can’t just wander out.”
Dave presents the following five steps to getting out of debt:
- Stop borrowing!
- You must save money
- Prayer really works
- Sell something. (His famous line: “Sell so much that the kids think they’re next!”
- Take a part-time job or overtime (temporarily)
The Debt Snowball
A key component of Dave Ramsey’s FPU plan is the debt snowball. You’ve probably heard about it and seen countless debates over whether paying off your debt this way make sense or not. I’ll admit that in most cases, this is not the most “interest-efficient” way to pay off your debts but as Ramsey himself states, this is about behavior modification not about math (”besides, if you could do math you wouldn’t be in debt to begin with.”). The debt snowball relies on seeing that you are actually making progress and that tangible progress motivating you to stick with it and make more and more progress.
Here is the debt snowball process:
- List all of your debts from smallest remaining balance to largest.
- Pay the minimum amount on each debt except for the first one. Put all the extra money you can scrape together towards paying off the first one as quickly as possible.
- When the first one is paid off, put all the money that you were paying on the first one towards the second one. So, the money from the first debt will be added to the minimum amount you were already paying on the second debt thus increasing the payment.
- Repeat this process for each subsequent debt. As you can see, the amount of money being paid on each debt gets larger and larger as you pay off the smaller ones – hence the “snowball” concept.
This debt stuff is important!
I feel that this is one of the most important lessons in FPU. Most people just assume that car payments, mortgages, home equity loans, credit cards, and so on, are just a way of life but it doesn’t have to be that way! We strove for a few years to pay off our cars early and get rid of my wife’s student loans. At one point, we were paying $800 on our cars and $2000 on student loans – that adds up to a lot of money each month! Now, we’re saving that money. Instead of giving away $2800 each month, we’re giving it ourselves. That’s a great feeling.
My parents never made a ton of money through their working careers. They rarely use credit cards, paid off their mortgage years ago, and live fairly simply though. As a result, they can basically do whatever they want in retirement without even touching the principle of their savings. They’re not just sitting around listening to the radio all day either. Their indulgences are going out to eat a lot, getting a new car every couple years (and they lease!), and taking a three-week vacation to Florida each year.
Get out of debt – keep the money for yourself! If you want to give it away, it’s a lot more fun to choose whom to give your money to instead of being forced to give it to your bank. And I’m sure your church or some missionaries or some people who are struggling need that money a lot more than your bank does!
Check out the previous FPU posts:
- Financial Peace University Lesson 12 – Real Estate and Mortgages...
- Financial Peace University Lesson 5 – Credit Sharks in Suits...
- Financial Peace University Lesson 11 – Working in Your Strengths...
- Financial Peace University Lesson 7 – Clause and Effect...
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Dave Ramsey is right about all these things. He makes very good points and the truth of the matter is that we all know he is right. We are fed these myths all our lives and then when push comes to shove it is all wrong. I suggust that everyone read his book and follow it like a religion.
Nice blog