One thing that I’ve come to realize over the years is that getting your finances together and winning financially doesn’t always make sense. In fact, sometimes, it defies financial logic.
There are a lot of reasons why this is the case, but for me the most convincing one is that we as humans aren’t perfect logical machines. Just because something is logical doesn’t mean that we’ll follow through with it. We often need help along the way, a psychological boost if you will.
Example – The Debt Snowball
One of the best examples of this is Dave Ramsey’s debt snowball. The debt snowball by all accounts is not the most financially sound way to get out of debt. It says that you should:
- List your debts from smallest to largest.
- Pay the minimum payments on all of your debts except the smallest which you pay extra on – whatever you can manage.
- When the smallest debt is paid off you roll the amount you were paying on that one into your next largest debt.
- Wash, rinse, repeat – until all your debts are paid.
Paying your debts off this way doesn’t necessarily make the most sense financially and Dave Ramsey admits as much. If you were to do it in the way that cost the least money, you would pay the minimums on all your debts, and then pay as much as you could towards the debt with the largest interest rate, and pay that one down as fast as you could.
The reason why Ramsey doesn’t suggest this method, however, is because it doesn’t take into account the human element. He says that debt elimination is about 80% behavior modification and about 20% head knowledge. You can have all the great debt reduction plans in the world, but if it doesn’t take into account human psychology it just isn’t going to work as often.
The debt snowball realizes that for a plan to be workable it has to help modify behavior to get you moving in the right direction. It does that by giving quick wins when smaller debts are paid off, giving you the psychological boost that is needed to keep moving towards the goal.
The other method, while it may save you some money, often does not work as well because you’re not as motivated by the quick wins – and you end up not working as hard towards the goal.
Another Example – Emergency Funds
Another example of a financial decision that doesn’t necessarily make the best financial sense could be the decision to fund an emergency fund.
A couple of years ago we were in the middle of re-funding our 6 month emergency fund. It had recently been depleted and we wanted to build it back up in case of a layoff or other emergency.
In the middle of our quest to re-fund our emergency fund we had the opportunity to get a good deal on a refinance that would have made good financial sense in the long run. In the short term, however, it would mean sacrificing some security as we took some of the money out of our emergency fund to pay for the closing costs.
My wife wasn’t comfortable with that. Her sense of security is tied up in that emergency savings, and without it she just doesn’t feel as good about where we’re headed. While the refinance would have been better financially long term, in the short term the best financial decision for us was to save up that money instead – so that my wife would feel more secure.
Because she knows I’m taking her feelings and well being into account, she’s more likely to be on board with our other long term goals now as well.
Careful Decisions Will Lead To Success
What I’ve learned through this process is that to succeed financially you have to be willing to make careful decisions about where you’re headed, and realize that success doesn’t always mean making the most logical choice.
Sometimes it means taking into account the psychology and human elements of the equation. Only when you do that will you truly be able to make the best decisions for you and your family.
Have you encountered a situation recently where you made a decision that you felt was the best, even if it wasn’t the best financially? Tell us about it in the comments!
Great post! Sometimes it’s all about psychology and trying to do the right thing when it comes to your peace of mind. We did our debt snowball the same way. It’s a morale builder to pay off the lowest first.
If we could all be entirely logical then the stock market would be a lot easier and we wouldn’t have a housing/credit crunch.
The human element is huge!
Nice work, Pete. I can tell you really wanted that refi, and it speaks good of your marriage that you were able to honor your wife’s sense of security like that.
Pete, I agree – managing your finances is often more about being at peace with your decisions than making the best “mathematical decision.” There is a lot to be said about small victories as well as peace of mind and the feeling of security.
Pete,
good post, it is so true. I have found that you can’t make every decision based only on whether it is good mathematically. There is more to life than money, so making all of our decisions solely on how they affect our wallets is a bad idea…
I am currently in a bind that fits this topic. My 18yr old daugther just backed into my 1yr leased car causing 1800 in damages. I have a 500 deductible but think I will use our emergency fund to repair rather than filing our 3rd claim in 2 yrs and having her have a claim after only one yr of driving. It’s hard to stay above water in life.
Bob, I’ve done something similar where our deductible was like $500 and the damage was $600-700 – and I just paid the little bit extra in order to keep my perfect driving record. In the short term it may not have been cheaper, but in the long run I think it makes sense.