When it comes to mathematics, certain facts are universally agreed-upon. For example, regardless of your culture or educational system, you must agree that one plus one equals two unless you mistakenly fall for an invalid proof. When dealing with money, why are people inclined to believe that one plus one does not equal two?

If you have a certain amount of money available to pay off a portion of your debt each month, even if that certain amount changes, there is a mathematically correct way of paying off that debt. You can call this approach the Debt Avalanche. It is similar to Dave Ramsey’s popular “debt snowball” method, with one small but important detail: With the Debt Avalanche you will pay off your debt faster and pay less total interest to banks and lenders.

The simple calculation for the Debt Avalanche requires only the interest rates for each debt account. This assumes that all debt accounts have the same tax liability, but if that’s not the case, determine your interest rate after taxes for this calculation.

Step 1. Order your debts from highest interest rate to lowest. You may find credit cards at the top of the list. It’s typical to see interest rates from 10% to 20% or more. Credit cards offered by stores often have the highest interest rates, so you might find these at the very top. Watch out for promotional rates ending, which they may do on the date promised when you enrolled, or earlier. Card issuers also re-evaluate their customers every so often, and will not think twice about raising your rates midstream. Note that if your credit improves, they will not magically lower your rates. While lenders will notify you if they intend to raise your rates, you may have missed the notice.

Your mortgage and home equity loan may be the next debts in line. It’s important for your list to capture every debt for which you make a monthly payment. Student loans may be the last on the list, particularly if you qualify for tax credits. The Debt Avalanche formula won’t work properly if it covers only a portion of your debt, so consider all accounts.

Order your list from the highest interest rate (after tax) to the lowest. You may have noticed we didn’t factor in your account balances in the above formula. That is because your individual account balances are irrelevant. The issue solved by the Debt Avalanche is the best way to pay off your total debt with all available funds.

Step 2. Pay the minimum to all debts every month. If you’re writing down your list, or using a spreadsheet like Excel, add a column next to each debt to list its minimum monthly payment. This is the amount you will pay towards each debt, except for the one account listed at the top of the list.

Another column should list the payment due date if it is relatively static from month to month. For example, my credit card payment is due on the last date of almost every month, so I would write “30.” This would indicate to me the last date of every month. Your payments should always arrive before the due date. In fact, in some cases, you can reduce your total interest paid by paying weeks in advance of your due date.

Step 3. To your debt with the highest interest, send all extra available cash. If you have an emergency fund, this step is simple. Since it’s unlikely that you can earn more in savings than you can “earn” (reclaim) by paying off your debt, all your unused income after paying expenses (necessary and discretionary as you see fit) should be dedicated towards the debt account with the highest interest rate.

Step 4. Repeat every month. You cover all your bases by ensuring every creditor receives the minimum payment, but you hone in on only your debt with the highest interest. Once a debt account has been eliminated—and it may not be the account at the top of the list if other balances are smaller—remove it from the list and re-order if interest rates have changed.

It’s that simple. This is mathematically the best method for paying off your personal debt. No other method will get you out of debt faster and save you as much money.

Despite the facts, many people disagree. The primary reason detractors, or supporters of the “debt snowball” method, may argue is that Dave Ramsey’s method will help you pay off your smaller debt faster, providing you with “early success” and possibly the motivation to continue along the path of debt reduction. The Debt Avalanche will also provide early success, but if you need special motivation to continue your monthly payments, consider this: By choosing the Debt Avalanche method, you will pay off your total debt faster, you will pay less interest, and you are mathematically efficient.

That is motivation enough. Or is it?

Dave Ramsey believes his “debt snowball” method, in which debts are paid off in the order of balance from lowest to highest, has shown better results than any other method thanks to “quick wins.” If he were to ask his followers if they want to carry their debt longer and pay more interest throughout before offering the “debt snowball” method, they would choose the faster, cheaper, better option of the Debt Avalanche.

One of the many reasons people can fall into debt is the difficulty of separating emotional thinking from rational thinking. The Debt Avalanche helps separate these two methods of thinking, as the best financial decisions are almost always the rational decisions. But it helps to pay attention to some of the psychology involved, as well.

The possible motivation due to the “early success” aspect of the debt snowball method is cited by many followers to be its strongest point, encouraging debt reducers to continue down the path. Followers of the mathematically and financially superior Debt Avalanche, if they need this sort of motivation, can achieve the same effect by defining milestones.

Rather than “celebrating” when your first full credit card or other debt account is paid off, take note and reward yourself when you’ve paid off your first $1,000 (or $500 or $10,000, whatever is applicable to you). Setting and achieving these short term goals influences the same area of the brain (the mesolimbic system) as the act of paying off the first credit card and are similar enough to provide the same motivational results.

Quick wins may help to motivate debt reducers to continue along the path, but the real win comes in knowing you’ve made the smarter choice.

Updated on July 8, 2008 with more information about redefining milestones to address the psychological effect of “quick wins.”

If you have variable rate student loans, mark July 1, 2008 on your calendar. After that date, you can lock in interest rates 3 percentage points lower than what’s available now. I’m not eligible for lowering the rates on my student loans because I’ve already consolidated and I have no new student loans to add into the mix. But if you haven’t consolidated yet, you may be able to benefit from rates as low as 3.62%.

I have about $11,000 left to pay on my student loans at 4.25%. As savings interest rates have decreased recently, I’ve been increasing the amount I’ve been paying to eliminate this debt. This loan is the only debt I have that requires interest payments, and I’ll be happy to pay it off.

Earlier this month I sent $750 to student loan repayment. That payment is up from $500 the month before, $250 earlier this year, and about $150 earlier than that. In July, I’ll either maintain my $750 payment or increase the amount to $1,000 depending on my June financial results.

Update! There are a lot of questions being asked already, so here are some details.

• Since many lenders no longer perform student loan consolidation, you may be better off starting your search with the U.S. Department of Education who will.
• Only variable-rate student loans are eligible. All student loans initiated after July 1, 2006 are fixed-rate loans, so these loans will not qualify for the lower interest rate, but you can still consolidate multiple loans to reduce your number of payments, your minimum due, and extend your total repayment duration.
• If you’re still in school, you are not eligible for the lowest rate. If you’re in the six-month grace period, you can receive the lowest interest rate on the loans that are over two years old (usually from your freshman and sophomore years). If you’ve waived your grace period you’ll only qualify for a higher rate.
• If you’ve already consolidated your student loans, you won’t qualify for the lowest rate.

Note: The Department of Education’s loan consolidation application will not indicate the new, low interest rate until July 1. Consolidation applications are on hold until that time.

3.6% student loans: Consolidate now, Liz Pulliam Weston, MSN Money, June 23, 2008.

A new study by researchers at Vanderbilt University Law School and University of Oxford reveals a strong correlation between approvals for payday loans and bankrupcty filings. Considering that people who are rejected for payday loans have other (limited) options for credit, it’s surprising that the rate of bankruptcy isn’t as high with this group. It’s quite possible that this can be interpreted as a cause-and-effect relationship. That is, being approved for payday loans increases the probability of filing bankrupcty.

Individuals who have been approved for payday loans have a probability of filing for bankruptcy within two years 2.48 percentage points higher than the probability for individuals who were rejected for payday loans.

It sounds obvious, but scientific findings that payday loans contribute to bankruptcy confirm any hunches. Payday loans a short-term loans with fees which, if viewed in terms of interest rates, are very high. Rates of 100% APR or higher are common. The loans are designed to be paid back in two weeks, however, so you only see a 100% interest rate if you roll over from one loan to the next for an entire year.

Most people who have the need to get cash quickly in the form of a payday loan don’t continue the cycle continuously for a year, but many do become repeat customers. The typical payday loan borrower will apply for about five more payday loans totalling over $1,500 within one year after the initial acceptance.

The study shows that interest from payday loans accounts for about 11% of the a bankrupty filer’s total interest burden, and this 11% could be what finally pushes an individual into declaring bankruptcy—the proverbial straw.

These results are consistent with the interpretation that payday loan applicants are financially stressed; first-time loan approval precedes significant additional high interest rate borrowing; and the consequent interest burden tips households into bankruptcy.

The authors of the research discount the idea that individuals preparing to declare bankruptcy quickly accumulate as much debt as possible to maximize bankruptcy’s “benefit.”

While it’s certainly possible to borrow money through a payday loan, pay the entire balance plus interest when it is due, and never become a payday loan customer again, this is not a typical scenario. Furthermore, those who have low credit scores may be rejected by payday loan companies and turn to pawn loans instead, with similarly high interest rates. Yet, the payday loan customers have the increased incidence of brankrupcty.

Do Payday Loans Cause Bankruptcy? [Paige Marta Skiba, Vanderbilt University Law School and Jeremy Tobacman, University of Oxford]
via Research Recap via pfblogs.org

This article was written for Consumerism Commentary by Adfecto, a mid-20s guy with a masters degree in engineering. He aspires to be wealthy and writes frequently for his own blog, Adfecto Abundantia.

When I purchased a home it was not a lifetime commitment. I view a person’s choice of housing first as a financial decision and second as a lifestyle decision. A house gives you place to live and the added bonus of potential price appreciation and tax deductions. If it is cheaper to rent then by all means that is the way to go. Owning your own home can also give you a tangible increase in your standard of living, but personally that is considered a distant second when compared to the financial benefits. What I find interesting is that so many people tend to make emotional decisions about the home rather than rational ones.

Frequently, when home owners find themselves with a little extra cash at the end of every month, the idea of paying off the mortgage is often brought up. Is early payment the right way to use the money? Should the money be invested instead? Is my real motivation to build wealth or to play it safe?

The first step in analyzing this decision is to compare the interest rate on the mortgage to expected investment returns. Historically the S&P 500 with dividends reinvested has returned 10.43% annualized from January 1926 to December 2007, and the current rate for a fixed 30 year mortgage is about 5.76% according to www.bankrate.com. Based on this simple comparison it is plain to see that in the long run you will build more wealth by investing than by prepaying your mortgage.

If you want to further hone this comparison of rates, next you can consider not just the entire history of the stock market, but also every 30 year rolling period of stock market data. Since 1953 the S&P 500 has returned at least 9.34% over every 30 year period which is again well above the interest rate for a 30 year mortgage. Plowing your money into prepaying your mortgage has a huge opportunity cost that will hurt your ability to build wealth.

Why then would people consider prepaying their mortgage? Most people consider their home as a safe investment, and paying off a mortgage as a guaranteed return. A certain piece of mind comes from owing the bank less money. There is a big problem with this argument; there is still a great deal of risk involved with your primary residence!

Additional risk comes from the fact that until your loan is paid in full, the bank still holds the mortgage on the property. The bank will not give you credit for the extra payments made to pay down the debt if you start to struggle further down the line. Even if you are way ahead on your mortgage, a hardship may cause you to miss payments. The bank can foreclose even if you spent years paying down the mortgage balance early.

Investing your free cash into your mortgage is very similar to investing in a bond. It may seem odd, but you are literally investing in a fixed income asset, the mortgage, lent to yourself. The return you get will be equal to the interest you would otherwise pay on your mortgage. One problem that arises is that the bank has first crack at the collateral; your house. Even worse, your mortgage isn’t even a very good deal when compared to the types of bonds; for example, Toyota AAA rated bonds currently pay as much as 7.652%. I bet your mortgage rate isn’t that high.

Furthermore, understanding the nature of your mortgage as a bond brings to light another risk; improper asset allocation. Mortgage prepayment shifts your asset allocation to rest more heavily in fixed income type investments than you might otherwise consider. A 40 year old person should have at least 60% but more likely 80% percent of his/her portfolio in stocks, but add in all of that mortgage prepayment in the bond category and you may find yourself far out of line from you ideal asset allocation.

Another risk related to mortgage prepayment is a lack of diversification. You may think that your mortgage is not very risky because you believe in your own ability to pay. This personal bias can cloud a person from see the true risk factors such as job loss, poor real estate conditions, natural disaster, and a plethora of others. A single unfortunate event can wipe out a large chunk of the equity. A single job loss may bring about a short sale or foreclosure that could wipe out the value of your home. Would you advise someone in your circumstances to invest in individual mortgages? I sure wouldn’t, and neither should you.

Deciding whether or not to prepay a mortgage is another financial and lifestyle choice which depends on several factors, but most of all it is a choice between building wealth (logical) and piece of mind (emotional). People who focus on paying off their mortgage seem to be more in love with their house and the idea of having it paid off than the goal of building wealth. These people are also blind to the risks that come from investing too much of their finances in a single residential structure. I think that for the majority of people the ‘right’ decision would be to keep the mortgage and invest the extra money.

Image credit: Oracio
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Countrywide, the country’s largest mortgage lender, is stepping in to “rework” 82,000 loans totaling about $16 billion. I believe that the lenders and the borrowers are both partly to blame for the mess. Lenders offer risky loans, and customers, happy to hear they can afford more than they anticipated, sign up without realizing they can’t really afford it.

When a company like Countrywide gives into consumer pressure, you can be sure other lenders will follow. While this is good for the economy in the short-term and good for the borrowers overall, it may send a bad message. It perpetuates the idea that there are no real consequences to being in debt. Bailouts extend the ability for people to survive while simply signing their paycheck over to other people and companies like mortgage lenders, electric and cable companies, and credit card issuers.

This is a dangerous thought: As long as you are following the spending trends of millions of other people, you are safe. There will always be changes in regulations or laws to keep the economy somewhat afloat, and if you’re representative of the greater economy, chances are you’ll be kept afloat as well.

While history shows that in general that has been the case it is a highly dangerous way of thinking, because it doesn’t play out that way for everyone, and you have no idea of knowing if it will for you. It’s a much better idea to live below your means and never have to worry.

Ah, student loans. The things that remember you long after you’ve completely forgotten the entire college experience.

Although I finished college in 1997 and graduate school in 2000, loan payments to Sallie Mae have been a constant fixture ever since, like a little wound I’d nurse which just wouldn’t stop bleeding.

Even when making double or triple monthly payments, the amount I owed hardly seemed to diminish at all. I set up direct deposit, did everything I could to nudge that low interest rate down even further, and eventually consolidated my loans, but I was still frustrated, unable to see that light at the end of the tunnel.

Perhaps this was because (and I’m actually facing this number in its entirety for the first time ever right now): that tunnel was pretty darned long. $52,050.74 long. Looking at it actually makes me feel faint.

And that’s just the principal – that number doesn’t even take the interest payments into account. I’m afraid to figure that total out.

I won’t say for a second that my higher education wasn’t worth it – it was just a bit of a hard road to travel, despite my high level of motivation and desire to be self-sufficient. My parents either couldn’t (Mom) or didn’t (Dad) contribute to my college education, so I waited tables like crazy throughout highschool, washed dishes for a whopping $4.50 an hour within the work study program once at college, and got student loans, both subsidized and unsubsidized, to cover the rest.

I still wasn’t anywhere near paying off the 4 years of undergrad study when, after several years in the workforce making double loan payments each month, I decided to go to graduate school. Another $18,000 added to the sum, and that’s because I chose to complete my Masters degree overseas, where it was cheaper.

That loan amount kept swelling like an engorged tick, but because it was in a flurry of separate disbursements, I never really faced the total, just a few thousand here and ten more thousand there. My interest rates were pretty good, so I’d just been paying it down monthly ever since, hoping one day to reach the elusive endpoint.

Last year, I started becoming more financially aware and contributing to my savings account. I was so happy that I had finally amassed some money in savings that was earning 5.25%, but then I noticed that my consolidated student loans were still costing me more than that in interest at a rate of 5.38%. And because of my salary, I don’t get to deduct a single penny of that interest from my taxes.

Because I was just paying under $200 a month, it didn’t seem that bad, but once I really got into crunching the numbers, I realized that I’d been paying around $75 a month in student loan interest, which turned into a big ouch when I looked at the cost annually. And despite all my extra piecemeal payments, nearly ten years later I still owed around $22,000 to my old friend Sallie Mae.

I sought the help of a financial advisor. She explained that although some of my residential and rental property mortgage rates appeared at first to be higher, after tax deductions, my student loans were hands-down the most expensive of all my loans.

Based on her advice, I decided to grab some cash out of my coveted savings account and start hacking away at the remaining loan amount, paying as much as I could whenever I found I had uncommitted funds at my disposal.

My tax refund and all my savings except my emergency fund went right to Sallie Mae, knocking off $10,000 from the total. I moved my emergency fund to a high-yield savings account earning 6% at FNBO Direct, and started funneling every extra penny into that account, elated each time I was able to transfer money in. The interest was a nice bonus, giving me more incentive to store funds at FNBO Direct before surrendering them, never to be seen again. Once there were sufficient funds in the account, I’d do yet another payment to Sallie Mae, $500 or $1000 at a time.

It felt like the wound was hemorrhaging, and I dreamt of having a nice big savings or investment account instead, but I remained committed to reducing that total.

And around 2 months ago, I finally got that total just under $4,000. The end was in sight! I started bringing more lunches, buying less clothing, socking away funds just a little bit more – anything to finish that final lap.

And today, I did it. I sent my final payment of $3,880, and bid my old friend Sallie Mae goodbye with a cheer.

The number was $52,050.74. It was outright terrifying, a giant monster that wouldn’t fit beneath the bed. And as of tomorrow, that number will be zero.

In ten years, I have paid off $52,050.74 in principal, and still more in interest. I say it again because now I like that number; now I’m very, very proud.

With the savings rates falling like bricks lately, there is no advantage to me keeping my student loan payments low while keeping my bank account in the stratosphere. My student loan interest rate is 4.25% and I may not qualify for any tax advantages which would otherwise effectively reduce that interest rate. My savings aren’t earning much more in interest, and after income tax, it’s likely less.

I’ve decided to speed up my student loan payments. I’ll end up with less cash on hand in the next few years, at the same time I might be purchasing a house, but the lack of debt will put me in a better position to afford a mortgage.

This week, I sent $5,000 to my student loan.

The most basic piece of knowledge one needs in order to be in control of their finances is the importance of awareness. Many people will go through their lives blissfully ignorant of their own financial details. Why? For one, ignorance is bliss. The more financial trouble you are in, the easier it is to ignore financial details because it keeps stress out of your life. David Bach is professing tips for dealing with home equity and debt, and for his fourth informative piece, he underscores the importance of being aware of how much your debt is costing you.

First, shop around for the best rates (check out Bankrate.com or LowerMyBills.com to compare lenders’ rates). Then, see if your primary mortgage lender can offer you a deal. But make sure you understand how it works.

For instance, is the loan tied to the prime rate? Is it fixed or variable? Variable rates can hurt if rates keep going up. Determine when that variable rate adjusts and what your new payment amount will be when it does.

Read the fine print: Is there an origination fee (even if you don’t use the loan)? Is there a property appraisal or application fee? Will you incur closing costs? Will your payment amount increase if you’re ever late? And finally, are there fees if you pay the loan back early?

When I was in debt and ignorant of that fact, if I didn’t start writing down my credit card and loan balances, the interest rates, and my monthly obligations—and later entered my information into financial software to track my spending and expenses—I never would have gotten myself in a better position. When you’re comparing home equity products with the intent of making decisions about home equity loans and HELOCs, you will not be able to make competent decisions until you understand the details.

You can’t just stop at the interest rate, either; as David Bach mentions, prepayment fees are important as well. If you want to pay your loan off faster than the provided amortization schedule, prepayment fees can take the place of the interest you think you’re saving. It gets worse. The more customers become aware of the “hidden” fees, the companies seemingly find new ways to confuse and distract.

Seven Ways to Be Home Equity Savvy [David Bach]