Monday, March 10, 2008

Sunk Cost Dilemma -- "Live like no one else today..."

"... So you can live like no one else tomorrow." Is a good quote used often by Dave Ramsey. I am not sure if he originated it, but I do like it. Dave Ramsey is one of the most vocal anti-debt voices out there in the world. What amazes me is that those who are vocally anti-debt like myself, are often those who were on the brink of serious financial disaster at some point. But some who were there get right back in debt.

My new theory is that there are two reactions to being close to financial ruin, fight back and change your ways completely or do just enough to survive another day. Those who fight back are often the ones who change their lifestyle enough to pull out of debt and if it was a serious amount of debt, they did that long enough that they hate debt if for no other reason but because they had to live a very limited lifestyle while getting out of debt. Every financial adviser has a similar blueprint as to how to get out of debt which goes something like this:
1. Establish a budget that minimizes expenses and maximizes debt payments.
2. Save a $1000 emergency fund so you don't pile emergencies on credit cards.
3. Pay off unsecured debts using either the debt snowball (smallest first then put all that money on the next largest) or by paying off the highest interest rates first.

This simple formula can be seen in the Wall Street Journal, Washington Post, New York Times, USA Today, by Financial Advisers like Fidelity Investments, by Dave Ramsey, and through ministries like Crown Financial Ministries. Whats amazing is the difference of what you do afterwards. Do you pay off secured debts or not?

Secured debts are those which have some backing collateral, like a car or a house. The difference between some of the advice and others is whether they suggest you pay off secured debts to eliminate the risk of debt in your life or not. The aggressive financial adviser wants you to start pouring the money into their service and quickly will point out that you can get a higher rate of return (they may quote anywhere from 8-14%) from mutual funds than your interest rate on your secured debt (4-7%), so its not important to dump the extra money into your secured debt. Others, like Dave Ramsey and Crown would point out that this is known as the sunk cost dilemma.

The sunk cost dilemma is an economic principle that points out that people who have already committed to one path (like paying a car loan, student loan, or mortgage) will choose to stay on that path rather than review if this really makes sense. For example, would you borrow against your house to put the money in the stock market? If so, you are a big risk taker, most would not. Well, this is essentially what you are doing with a mortgage if you are putting money into the stock market instead of paying off your house.

Dave Ramsey and Crown would also point out Proverbs 22:7, "The Borrower is slave to the lender."

The bottom line is, "Live like no one else today." Don't fall prey to the sunk cost dilemma. Pay off the secured debts as well. Then, when you have no debt and can pay yourself a lot more, you will "live like no one else tomorrow."

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