If you don’t know who Dave Ramsey is, he is the author of various financial books that have obtained a cult following status. There are religious undertones to his books and systems, but this article will focus strictly on the financial benefits/losses of what he says.
In the real world, you basically either care about your finances or you don’t, there is very little in between. If there was such a thing as a “financial grades,” it really wouldn’t be a bell curve, in fact, you would have maybe the complete opposite, Lot’s of D’s and F’s (many who think they are C’s), and lots of A’s and B’s.
I would argue that Dave Ramsey is taking a bunch of D and F students and turning them into C students (maybe B-‘s). I congratulate Dave Ramsey’s for his efforts in getting people to think about their finances.
So there is a “net gain” by his efforts (aside from the income from his books), but at the same time, if you really want to be an A+ personal finance student, you simply cannot follow his advice.
Most of what he suggests in his step program is obvious, but there are a few quirks.
- Step 1 – Save $1,000 for emergencies (My only quarrel is that this amount isn’t large enough, but that’s solved later in Step #3)
- Step 2 – Pay off all of your non-mortgage debts smallest amount to largest. Laughable advice that completely undermines basic concepts of finances. By making this statement, you effectively are stating that your audience does not have the mental capacity to understand finances, and that the only way you can herd them into paying off debt is to offer them a reward as soon as possible. Maybe Dave is correct, maybe his audience is not smart enough to understand the basics of finances, that’s a separate argument. We will dig into this step in a moment.
- Step 3 – Save 3 to 6 months of expenses (growing emergency money, cant argue with this except you really should be stressing the full 6 months.)
- Step 4 – Invest 15% of your household income into Roth (after-tax) and pre-tax investment vehicle. Not bad advice at all, but a little unclear due to the fact he is mixing pre-tax and taxed in at the same time. Is it 15% Gross Income or 15% Take Home? Maybe he digs into this more in the book (I hope he does, but really lacking in financial explanation of what he is even implying)
- Step 5 – Save for a college fund for your kids. Thank you for bringing this up Dave, I completely admire it, but he talks about 12% returns and really doesn’t mention the actual amount needed for your kids. Twelve percent is very aggressive, if only you could obtain this with relatively low risk. He mentions that if college costs goes up by 4% and you gain 12%, that’s a 8% net. Now lets imagine you have a newborn, how much do you think you have to save each month to provide $20,000 a year for 4 years (inflation adjusted)? Chew on this number, $357 a month even at the highly aggressive 8% net rate he talks about. So two kids, roughly $700 a month (starting from they day each child is born).
- Step 6 – Pay off your House Early – This advice is beyond laughable, it’s very financially detrimental to people. In the last step he mentioned 12% returns, what happened to the thought of growing money for yourself? Why in the world are you paying down your 4.5% (net after deduction for most below 3.5%) mortgage? Furthermore, you are losing leverage on your house that is pegged for the most part to inflation. This advice is so terrible, we have to dig into the actual damages later.
- Step 7 – Build Wealth and Give – Great advice, although I’m not sure what it adds to the idea of actually building wealth, but I agree giving is important.
Step #2 Problems
So now let’s dig into the problems, starting with the paying down smallest debts regardless of rate.
- Credit Card @ 22%: $7,000
- Credit Card @ 21.7%: $4,000
- Car Note @ 4.6%: $2,500
- Student Debt @ 5% (deductible): $6,000
If you had $2,500 cash extra in a year, would you honestly pay down the 4.6% debt over the 21.7% or 22% debt? If you did, your effective loss is $2,500 @ 17.4% (22 – 4.6), over $400 of opportunity loss (which is almost 20% of the amount you paid down).
Meanwhile, your high interest rates exponentially get worse. You grow higher rate debt, while tackling smaller possibly irrelevant amounts. This advice is absolutely a violation of the most basic financial concepts that exists. If there are no additional rewards/penalties to consider, the decision of “what to pay,” is very simple. Whatever yields the highest net rate. Remember that student interest is deductible and sometimes even forgiven. Now I understand there is a mental reward to “making the final payment,” but if we are strictly talking financial terms, you simply cannot follow this advice.
Step #6 Problems
The next bad advice is paying down your mortgage. For this example, $250,000 loan at 4% (current rates) with a 25% marginal tax rate (effective rate is 3%).
I’m going to talk about tossing another $500 a month into your mortgage. If you did this, you would pay your loan off 12 years and 9 months early (17 years and 3 months of payments).
So let’s compare our options here.
You can pay $320,199 ($1,546.85 a month) over 17 years and 3 months 207 , or
You can pay $379,444 ($1,054 a month) over 30 years.
Net Savings of $59,245, but what about opportunity costs.
Let’s compare if you save the difference and invest it at a rate of 8% net a year (since 12% is apparently possible according to Dave Ramsey)
$500 a month over 30 years invested at 8% = $745,190.66
Now the house will be paid off at year 17 month 3, and in theory you can start investing the entire $1564 a month for the remaining 13 years = $426,850.31 for the alternative “pay down your mortgage” participant.
Net loss from Taking the “pay down your mortgage” advice = $745,190 – $426,850 = $318,340 or roughly $10,000 a year in the wrong. Obviously this advice gets worse the more you put into your mortgage.
It’s also important to note that you have locked up all that money in your house that will only grow with appreciation rates. If you house appreciates $10,000 in value in a given year, you receive that $10,000 whether you have $0 of equity or $250,000.
You have effectively destroyed any of the opportunity above 3% return of every dollar placed into your home.
Dave stresses “Freedom” a lot in his work, but let me ask you, how much more free would you feel if you had $318,000 additional net worth after the 30 years.
Also how “free” do you feel during the 17 years and 3 months you are paying an extra $500 of your after tax money into your house? Now I understand it can be hard for individuals to have the will power to save the $500 into an investment account, and maybe that’s ultimately what Dave Ramsey is trying to actually say in his work. Maybe he is saying, unless we have a “goal,” we will fail, but with a goal, we can be a C student.
I respectfully disagree with Dave Ramsey, we have the will power to make the A+ decisions and ensure our financial security.
One final thought, you ever notice that these programs never (or rarely) seem to focus on spending less or making more money? Because people don’t want to hear “you shouldn’t be driving your car,” “you should have the new iPhone,” or “you need to get a part time job.” They want to be told secrets or systems that will allow them to be wealthy. Furthermore, who exactly is his audience?
If you are cutting out 15% of your income, then saving $700 a month for your kids college, and then paying basic unavoidable expenses, what exactly is left?
If you have $4,000 take home and you have to take 15% out, then $700 a month for college funds, and then your actual expenses (housing, clothing, food, utilities, phones, etc.), how much can you actually pay additionally towards your mortgage.
The truth is, I think the people who this book probably appeals to the most, need to avoid his advice the most (need the maximum growth/return). The problem is we are always hearing about people who did something extreme (paid down $100k of debt, etc.) but we usually find out their income is fairly high.
So thank you Dave for helping people have some goals, but please trust people enough to make the best decisions. Maybe write an “Advanced Dave Ramsey Steps” book. Just do me a favor and make a subtitle “: So you Actually Want to Maximize your Returns.”
Who knows, maybe you could sell another 4,000,000 books?