We've all been following Pete's series on Dave Ramsey's baby steps program with the utmost interest. As someone that has never struggled with debt, the need for the program has never presented itself to me. However I discovered his radio show in college, and really like the call-ins from listeners with financial problems. The show was successful in inspiring me to proceed through life with a debt-averse attitude.
But between listening to Dave on the radio and listening to financial planners and my finance professors, a general consensus emerged that Dave may not be doing what is best for someone looking to get their financial house in order.
Examples? Okey dokey. Let's start with the simpler things and work our way up.
Examples Were Dave Ramsey Is Wrong
Say you're in step 2, making that debt snowball. You've got $1,000 credit card balance at 12% and a $1,500 credit card with a 15% rate. Since Dave wants you to start with the smallest debt, he is asking you to pay off the credit card paying at a lower interest rate! If you wanted to save a little on interest payments, start with the $1,500 credit card charging you 15%, otherwise Dave is just telling you to throw money away. You've heard that one before I'm sure; Pete even covered it.
But now say you've got a $2,000 balance on a HELOC at 6%, and a $10,000 car loan at 5.5%. Well by your rules and mine it makes sense to pay down the HELOC. Wrong again. HELOC interest is tax deductible, plus the minimum payments are often very small. Use the HELOC to pay off the car, and now you have $12,000 in tax deductible debt and the advantage of smaller payments in case money gets tight. As a bonus, sell the car and get a “beater,” using the proceeds to pay down debt.
Interest rates are fine and all, but Dave isn't just about abolishing debt, he wants you to invest too. Dave tells you to invest 15% of your income, and that you can expect a 10-12% return. As a 20-something just starting out in my career, this may be appropriate. But as a 30-something, if you're just starting to invest for retirement, 15% will not be enough. If you're clearing your debt at age 40, you'd be lucky to get decent retirement before you hit the ¾ century mark. Why? Because the median family income in this country is $50,233. Less than 16% of families make more than $100,000 a year so your chances are slim. If you're 30 and making $50,233 a year and invest 15% of your income, you will not have enough to retire on in 35 years.
Another problem with Dave's investment advice is risk tolerance. Dave suggests you diversify your investments into four categories:
- Growth & Income
- Aggressive Growth
Every one of these categories is more risky than the S&P 500. This makes for a larger potential payoff, but you need only to look at sub-prime loans to see how the risk/reward relationship works. A proper balance should include bonds, value stocks, and index funds. As you get nearer to retirement, you will want to move closer into bonds. Their fixed income will reduce your potential return, but increase your chances of preserving what you've made. As someone who understands the risks of investing better than most, I would laugh at someone who thought they were diversified with a any portfolio balance of just the 4 categories above.
And what about that 10-12% return I spoke about earlier? If there is a mutual fund out there that has averaged 12% for 30 years please point me to it; because I haven't found it. A common error made by Dave Ramsey and anyone else out there that talks about investments is the fees in mutual funds. Vanguard, the prince of cheap funds, has expense ratios of about 0.15% for it's index funds. But Ramsey's recommendations aren't index funds, they are managed money funds. Managed money funds range from 0.5% to 2% or more in fees! So even if you find that wonderful 12% returning mutual fund, take a look at how much of your 12% is eaten by fees. A much more realistic expectation is 8-10% in true returns.
Dave Ramsey Can Still Help You Get Out Of Debt
Okay, so I've established that there are some mathematical flaws in the Dave Ramsey plan. Wow, I'm probably the first person to do that, ever. But I'm not here to tell you Dave's plan is a failure. I actually believe that no one out there can help you get your finances in order better than Dave Ramsey. Yes after wasting all your time above, I'm now telling you how great he is. Money is 75% mental, and Dave knows that better than anyone else. He designed a plan that helps you get your mind in order first. No one can motivate you better, no one has the powerful support structure, and no one has as many success stories as Dave Ramsey. If you are looking to get debt free, Dave is the way to go.
The caveat to this comes after Baby Step 3. When you're on Baby Step 4 and setting up your investments, make sure you do due diligence. Read, research, regurgitate. That is to say absorb investment books and read finance blogs, then conduct your own research about investments, finally go and talk to an investment councilor. As Dave says, “find someone with the heart of a teacher”, but also find someone who is not paid on commission.
This is an article from Philip over at http://www.weakonomics.com. Please check out his blog where he writes about personal finance in an edgy, yet entertaining way. You can subscribe to his RSS feed here. I may not agree with everything he's writing here, but I think it's important to get more than one viewpoint.