I’ve been looking for a good real-world example to compare the traditional “debt snowball” approach to the approach of paying off the high-interest loan first above all. Today, I received a note from a reader named Bryan:

I just graduated college this year, and am starting job where I’ll make $47,000. I’ve got significant student debt, which I will try to pay off as much as I can the next couple years (while my responsibilities are minimal).

My question is this:

I have 3 loans:
- $5000 @ 3.75%
- $11000 @ 6%
- $40000 @ 8%

Which one do I focus on paying off first?

It seems like the largest one with the high interest. But I could “snowball” it, and pay off the smaller ones (while paying minimum on the large one), and then use that money to hit the large one hard after the small ones are paid off.

What are your thoughts?

In order to see what the minimum payments would be on each loan, I headed over to Bankrate.com’s amortization calculator. I assumed that each debt was for ten years, so given that assumption, here are Bryan’s minimum payments:

The $5,000 debt has a minimum payment of $50.03 per month.
The $11,000 debt has a minimum payment of $122.12 per month.
The $40,000 debt has a minimum payment of $485.31 per month.

These debts total up to $657.46 a month.

Let’s also assume Bryan is going to devote 25% of his pre-tax salary to taking care of this debt, $11,750 a year, or $979.17 a month.

The Debt Snowball Method

Using the traditional debt snowball method, Bryan would focus on paying off the smallest debt first while just making minimum payments on the rest.

The first debt Bryan takes the $321.71 extra each month and applies it to the smallest debt. He would have this first debt paid off in fourteen months.

The second debt At the fourteen month mark, Bryan takes the extra $371.74 each month and applies it to the $11,000 debt, which because he’s been making the minimum payments, now has only $10,029.12 to be repaid. He would have this second debt paid off at the thirty six month mark.

The third debt At the thirty six month mark, Bryan takes the extra $493.86 each month and applies it to the $40,000 debt, which because he’s been making the minimum payments, now has only $31,137.16 to be repaid. He would have this third debt paid off at the seventy two month mark.

The “Highest Interest” Method

Using the highest interest method, Bryan would focus on paying off the highest interest debt first while just making minimum payments on the rest.

The first debt Bryan takes the $321.71 extra each month and applies it to the highest interest debt, the $40,000 debt. He would have this first debt paid off in sixty one months.

The second debt At the sixty one month mark, Bryan takes the extra $807.02 each month and applies it to the next highest interest debt, the $11,000 debt, which because he’s been making the minimum payments has only $6,226.32 to be repaid. He would have this second debt paid off at the sixty eight month mark.

The third debt At the sixty eight month mark, Bryan takes the extra $929.14 each month and applies it to the remaining debt, which because he’s been making the minimum payments has only $2,397.76 remaining to be paid. He would have this final debt paid off at the seventy one month mark.

Which Method Wins?

The “highest interest” method obviously gets the debts paid quicker, which means that Bryan would pay less in overall interest by going that route. However, with that method, the “successes” don’t start happening for more than five years. With the debt snowball method, the successes occur more regularly through the process, meaning it’s better for keeping your encouragement up as you repay.

For me, I would still go with the “highest interest” method - it simply puts more cash in your pocket in the end. I would also advise Bryan to never make more than the minimum payment on that 3.75% debt, because he’s cash ahead by even putting money in a high-yield savings account than making early payments on that one.

My wife and I made a batch of homemade cookies last night, completely from scratch. Oatmeal chocolate chip. The temptation was intense, but I only ate one, as per the ongoing Volumetrics diet. I used to eat four or five of them alongside a glass of milk, so it’s definitely a step in the right direction.

Are Pets Worth The Price? A very interesting continuation of the ongoing pet discussion… it started on The Simple Dollar a few days ago and has continued in various places. (@ queercents)

When Paying Off Doesn’t Pay Another excellent Ben Stein column where he lays out the facts about prepaying your mortgage. (@ yahoo finance)

The Simple Dollar Retro: 15 Things You Can Do Right Now To Help Your career A nice little collection of career tips that you can use to get ahead during those spare moments at work.

I received an email from a college student today, who I will call Erica. She told me the following:

I’m a 19 year-old university student. I have no debts and all my university fees are covered by scholarships. I live at home, so I have no rent or household related expenses. Since I have had a job since I was 13, I currently have $25,000 invested. This summer I landed an internship where I make $750.00 per week. I have very few expenses and a decent income. I have been looking for budget advice, but very little seems to apply to me. Do you have any suggestions? Also I am planning on getting my Ph.D. in Economics, so I will be in school for quite a while.

Erica is off to an incredibly solid financial start in life and has all of the opportunity in the world in front of her. She has basic financial sense and some good career sense as well; she’s obviously setting herself up for a great life. So what should Erica do with her good fortunes? Here are a few things I recommend for Erica - and for anyone else in a similarly good situation early in life.

Give yourself a very simple budget and stick to it With no debts and only minimal expenses, most of Erica’s money this summer could potentially be invested. I would budget a small spending stipend from each check (it really depends on your lifestyle), cover all expenses, and then automatically invest the rest somewhere else. You’ll have some very large expenses to cover later on down the road - if you can sock some money away now, all the better.

Start a Roth IRA Erica is likely to be far below the income threshold for a Roth IRA now, but late in life she will likely be in a rather high tax bracket. Take advantage of the tax shelter now and use some of that investment money from the internship to fully fund a Roth IRA this year. Funding $4,000 into a Roth IRA at age 19 means that it will have a worth of $181,037 when you can take it out at age 60 - and you won’t have to pay a dime in taxes on any of it.

Put the money in something simple There’s no reason to worry about portfolio management. Just invest in a low-fee broad based index fund. I’m a big fan of Vanguard and I strongly agree with their low-cost investment philosophy. If you want to really dig around and learn more, try reading The Bogleheads’ Guide to Investing.

Here’s some additional advice that might apply to Erica, not directly financial but quite valuable nonetheless:

Build relationships with people at the internship and at college Build a strong connection with people while you’re there and make every effort to keep in contact when you leave. These will be great professional contacts to have down the line. If you’re like me and this sounds like an “easier said than done” task, I really recommend reading the book Never Eat Alone - it’s a great look at how to do this well.

Follow your interests It’s your life - follow the things that excite you, not the things that excite other people that you merely go along with. College affords you the opportunity to really figure out what your interests are - don’t miss out on it because you’re worried about fulfilling expectations.

Be involved Find an organization or two that really speaks to your interests and get involved with gusto. The others you find there who are also deeply involved will likely be people who will match up well with you throughout the rest of your life.

Good luck, Erica. You’re already off to a great start.

Over the weekend, I had an IM conversation with an old friend of mine in which he stated that he felt guilty about spending $50 on a video game. This led us into a lengthy discussion about frivolous spending and guilt, and we found that his guilt threshold is substantially higher than my own. I tend to feel I’ve wasted money each time I spend more than about $5, while he generally doesn’t feel guilty unless he spends $50 or more.

Very interesting, I thought, so I conducted an informal poll of several people asking how much they have to spend frivolously at once before they feel guilty, and what did I find? There was almost a direct connection between their debt levels and the amount of money they felt guilty spending on frivolous things.

In almost every case, the higher the debt level, the higher the “guilt money” level. This wasn’t surprising to me: people who spend more than they earn tend to have an inflated sense of how much spending money they have and thus their concept of what they can reasonably afford is inflated.

What is surprising is that in almost every case, the lower the dollar amount that triggers guilt, the better the financial shape of the person. This is completely independent of income, actually - I tend to be among the high end of the people I surveyed in terms of income, but my “guilt level” is actually much lower than most respondents (sadly, it used to be very high). The result? My financial ship is pointed in a very healthy direction.

What can be learned from this?

First, evaluate all of your individual frivolous purchases. Look at your last few credit card statements and identify the ones that made you feel guilty after the purchase. What sort of spending threshold do you have to cross before feeling guilty?

Next, concentrate on those purchases that are expensive enough to make you feel guilty. If the purchase is more than that dollar amount, ask yourself whether you really need it and think about the feelings that other such purchases have generated.

After that, focus on questioning your smaller purchases. If you don’t feel guilty buying a hardback book once a week, ask yourself whether or not that $20 each week might not go to spectacular use somewhere else. Remember, that’s $1,040 a year, enough to partially fund a Roth IRA or make a big chunk of an extra house payment.

Remember, guilt can be a powerful motivator if it’s actually used for positive change. Don’t try to ignore it, but welcome it as a method for your psyche to give feedback on the things you’re doing right - and the things you can improve on.

Just for kicks, how much money is your “guilty money”? If you want to, share it in the comments.

The July 2007 issue of Money Magazine has a nice big cover story on entrepreneurship, a topic that interests me more and more as I grow older and start to create more revenue streams. As usual, though, the issue had a lot of interesting points inside - here are ten that really stuck out at me:

Traveler’s checks are pretty suboptimal in the modern era. Their fees are really high compared to ATM usage. If you’re going to travel internationally (particularly to Europe), just get cash with your ATM card and if you want an emergency reserve, just sock away raw cash someplace safe. (p. 21)

When you’re interviewing for a job, tell a story. Go in there ready to tell a story about your biggest success at your previous job. Better yet, have two or three. Then, when the opportunity presents itself, tell the story - it will do wonders to sell you to the interviewer. (p. 22)

You can do much more with your charitable donation and time if you focus on one charity rather than several. It takes a lot of people making small donations to have the same impact of one person making a solid donation of time and money, so if you really want to help out a charity that really means something to you, focus exclusively on that charity. (p. 34)

If you get a big inheritance, don’t spend it right away. Sit back and actually look at where to put it - you should also contact a CPA and figure out the tax implications before you do a thing. (p. 39)

Why would you want a financial planner? I still don’t understand why a financial planner is useful for anyone who isn’t worth well into the eight figures. With anything less than that, you can easily manage it yourself without a planner eating you alive for the sake of their own profit margins. (p. 43)

The S&P 500 may still be undervalued, after four years of a bull market. I still don’t feel great about investing in stocks right now, but the magazine makes several good points, including the fact that the S&P 500 is still undervalued (a lower-than-average price to earnings ratio compared to the historical average). Interesting… (p. 60)

A diversified portfolio is better than simply investing in what you know. Some investment gurus preach about focusing your investments on what you know, but it turns out that you’re far better off investing in a broad array of things. Another thumbs-up for broad based low cost index funds, I guess. (p. 66)

Their entrepreneurship guide overlaps with most of my guide to self-employment. Much of the same advice is focused on: get your business started while you’re still employed and plan very carefully to make sure you aren’t making a financial suicide leap when you do quit. (p. 81)

People who marry solely for money have issues. Thankfully, the article on how to marry a billionaire was done entirely tongue in cheek (I hope). (p. 94)

Whole Foods isn’t perfect. It’s basically an organized farmer’s market and offers an abundance of organic produce, but that doesn’t guarantee that everything on the shelves there is wonderful. Honestly, I prefer actual farmer’s markets - the prices are better and you actually get to meet the people that make the food. (p. 114)

I received all of the back issues for Make Magazine for Father’s Day and one of the projects details how to modify the case of an Atari 2600 to function as a DVD player. Even though we’re in the process of moving, I’ve been collecting the parts - it’s the first thing I plan to build on my workbench in the garage. I’m such a nerd.

Lessons Learned from Diet Books: How to Think Like a Rich Person After starting on Volumetrics (my doctor suggested it) a week or so ago (and losing four pounds already), I’ve read the book cover to cover and I can clearly see that much of the same logic applies to both personal finance and diets. (@ my open wallet)

Experience Review: Two Men and a Truck I had been considering a moving firm to handle our move in July, but I hadn’t moved forward with it. Two Men and a Truck was one of the ones I was considering, and after reading this review, I’m leaning more towards it than ever. (@ consumerism commentary)

The Wal-Mart Dilemma - To Shop Or Not To Shop? I debated the whole Wal-Mart issue a while back, but this article brings up several interesting points. (@ money, matter, and more musings)

The Simple Dollar Retro: The Art of the Thank You Note A handwritten thank you note is one of the best gestures you can do to improve your image, simply because so many people blow it off as being unimportant. Here’s a guide to writing one.

Quite often, I focus in on credit card debt as one of the biggest pieces of the puzzle for escaping a bad debt situation, and it is. One area, though, that I often overlook are other forms of consumer debt, particularly those where you purchase an item on a payment plan, then realize when you do the math that the interest rate is obscene.

I was once in this boat, paying off about $4,000 worth of furniture, a huge television, and a high-end computer all on payment plans. The payments seemed reasonable - about $120 a month - but when I first started realizing how bad my debt situation really was, I sat down and started looking at the real interest rates I was paying. Ouch. 30% interest for this computer? 18% interest on the furniture? That’s worse than a credit card!

What I found, though, is that there are different tactics you can use to escape this sort of debt. You don’t have the convenience of just flipping over a card and asking for an interest rate reduction because you’ve agreed to this plan, but you can take advantage of some other features to get rid of this absurd debt much more quickly.

First, read over your agreements carefully. Most agreements allow you to prepay the debt if you wish; in effect, it’s not really that different than a credit card, except the interest rate is tightly fixed and thus so is the payment plan (effectively the same as a minimum payment). If you’re not sure, call the phone number on your last bill and inquire about prepaying. You do not need the money in hand to do this - we’ll get there in a second.

Once you know which ones you can prepay, total up your outstanding balances on those debts. These are usually listed on your statement. You should also note the interest rate on each one - likely the rates are going to be fairly high (above 10%).

Once you have this master list and have added up the debts, collect your last statement on all of them and head to your local credit union. Inquire about a personal loan and ask to speak to a loan officer. When you’re discussing this, show that person the debts you wish to pay off with the personal loan and tell them that the reason you’re doing it is to get the debts paid off quicker. Unless your credit is in shambles, you’ll probably be able to get a personal loan up to a reasonable percentage of your salary quite easily, usually enough to pay off most of, if not all of your debts.

Now, deposit that check from the credit union and pay off those debts! Get rid of all of those debts from your life all at once, leaving you with only one debt to replace them - that to the credit union. This actually should help your credit, as it will show that you’ve paid off several loans.

You’re still left with that credit union debt, though, so don’t let that slide. I recommend taking the amount you were paying on all of those payments and channeling it into this credit union debt. What you’ll find is that since the credit union interest rate is much lower than the payment plans, you’ll be able to pay off this debt much quicker than you would have ever been able to finish off your payment plans.

When everything is paid off, breathe a big sigh of relief, but then take a look at your other debts. Could you not take most of that credit union repayment amount and apply it to your credit cards, your automobile, and so on to get them paid off quicker? Or, if they’re all low-interest debts, maybe you could dump that into your 401(k)?

There is hope, no matter what the situation.

I received a very long email from “Tony,” a long time reader, who had this to say (among many other things):

I absolutely hate my job but it pays so well that I can’t quit. So I go into work each day dreading it and when I get home at night I am just drained and all I want to do is watch TV and veg out.

Those two sentences struck a real chord with me because they speak directly to the life experience of a lot of people. They are tied to a job that they’re unhappy with for financial reasons, because quitting and moving to a different employment situation would be a financial disaster.

It’s been shown time and time again that job stress is detrimental to quality of life and also to health in various ways, yet many people work in jobs that make them miserable in order to earn a few more dollars. They put themselves in a financial situation where they have to make a certain salary in order to maintain their life and continue making payments on the things that they already have.

If you’ve found yourself in this situation, realize that there is likely no immediate “out” short of bankruptcy; you’ll have to live with the situation while you refactor your life or find another job.

Having said that, “getting out of the rat race” is a legitimate investment goal. If your goal is to work frenetically for several years and save so that you can enjoy a simpler job with lower salary and free time to enjoy your interests, that’s as noble as any other investment goal. However, if you’re currently “locked” into your job, it’s going to take some significant work to get there.

A big first step is to pay off all of your debts. Debts are the biggest factor most of us have in terms of required expenditures each month, between paying off student loans, a car payment, a house payment, credit card payments, and so on. These can be eliminated with focus and commitment.

The “debt snowball” method works well for this. In essence, just take 10% (or greater) of your pretax income each month and directly apply it to debt repayment. Make the minimum payment on every debt you have, then apply the remainder of your debt repayment money to the smallest debt. When that’s paid off, move on to the next smallest, and so on, each time adding to the “snowball” the minimum payment of the debts you’ve already paid off.

Once you’ve done that, focus on investing that snowball in places that will earn a steady income for you. You’re looking for something that will be able to sustain you when you quit that job, so focus in on investments that earn a consistent return. A high-interest savings account is appropriate here. For the time being, keep rolling income from these investments back into itself.

What you’re seeking now is the crossover point: that point in time where your investment income and your new work income can sustain you. When you’re there (or very close), quit and enjoy the freedom!

That sounds like a long way off. It’s only as far off as you choose to make it. Instead of dining out every night and blowing money on entertainment expenses to ease the pain, buckle down and start tossing money furiously at your debts and watch them melt away. As the debts get smaller and smaller and you find yourself reaching financial freedom, it’s amazing how much freer you will feel.