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
- Growth & Income
- Aggressive Growth
- International
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 Weakonomics. Please check out his blog where he writes about personal finance in an edgy, yet entertaining way.
Here is what I’m taking away from this article…
I do not agree with everything DR teaches either, however as Phillip said above, getting your finances in order is a “mental problem” first. You need to find a plan that will help motivate you first & foremost. Once you are motivated by that plan, then you have that plan to stick to. If you stick to that plan, even if it has a few flaws here & there, you’re still 100% better off than you were before you entered into the plan.
That being said, I do not choose to stick to any plan, but enjoy reading about many different plans then formulating my own. I treat it like I do a good recipe…
If I want to make a good homemade lasagna, I read the top 10 lasagna recipes on different websites, then combine them all according to my individual tastes creating my own personal lasagna recipe.
The same philosophy can be applied to personal finance, if you have the discipline. If you do not have the discipline, simply grab a plan like Dave Ramsey’s and stick to it!
Thanks Phillip.
DebtFREEk!
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Take a look at American Funds AIVSX, inception 1934, return since inception 10.12%
LRGs last blog post..Thinking about buying a home in 2009?
LRG, I will have take your word on the returns of AIVSX. However with a management fee 0.54% you’re looking at an annual return of 9.58%. I did say in the article a realistic expectation is 8-10%. Bonus: there is a front-end load of 5.75%, which means your $10,000 investment actually starts out worth $9,425.
I’m gonna have to disagree with that info. When mutual funds post their returns, they are after management fees. The load is a valid point, but if you are planning on holding it for a long period as in the example, B class shares will get you around that problem. Just a thought.
In regards to the article, I agree that investing and money are probably more mental than anything. That’s why it’s so hard for the average investor to “beat the market”, because emotions tend to encourage buying high and selling low, which is what we know you don’t want to do.
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Yes that’s a good point. I found that fund within a few minutes of searching. I expect that if I looked a little harder there would be one in the 10-12% range. You just talk about it like Dave just made it up from thin air, that’s all.
LRGs last blog post..Thinking about buying a home in 2009?
He’s not making it up, he’s just a bit optimistic. The funds exist, they are just few and far between. With most of us investing in 401(k)s and IRAs, we don’t have every choice for every fund. So the odds of us getting the choice of a fund that actually returns that much after the fees is even more lessened.
Phillip,
I’m not sure if you have read any of his books. In his books he states that his math is wrong on the snowball approach.
Also, “no one” should invest in any fund and just close their eyes for 30 years and hope for the best. You will very likely not make 12% yearly return. However, if you have half a brain, you will likely be able to make small corrections throughout the years that will get you to 12% or higher. Again, in his books, he states to look for funds with 10 year gains of 12% or more and then diversify.
I am very disappointed in the above article. I am a math guy and totally understand the first part of the article… but Dave faces this exact question from a caller at least once a month. If you were so smart to figure out how much borrowing was costing you, then you wouldn’t have borrowed in the first place. Dave answers every caller with an answer that points to the emotional success of a debt paid off – there isn’t a button on the calculator for that. This very element is what makes people STAY motivated – the $60 they saved by moving money is moot if they “fall off the wagon”. Dave is a master speaker and motivator and is very purposeful in his ways.
The next section you attack his 15% idea, but then don’t ever show any math. Even at 8%, you would save up $1.4million. Don’t hate on Dave for being optimistic with his 12%, realize that you wouldn’t tune in for a pessimist spouting off ROI’s in the 2% range. The $1.4m is WAY more than most people making $50k would ever dream of saving – plus on his path they would have a paid off house, paid for cars, kids they helped through college. You also say that 15% wouldn’t be enough for retirement – in a world where MANY are living on Social Security. Dave’s plan also talks about only using 8% of your savings/year = $110k/year at retirement, work that backwards for 35 years of inflation and it looks like $40k in today’s money. So a person who lives on AND SAVES 15% of their $50k income can’t survive on the equivalent of $40k at retirement? I feel your logic is quite shortsighted.
I rejoice in having crossed paths with DR. I have shared my learning with dozens of people and many of those have drastically changed their lives for the better. For every couple of financial lives he is changing, he is also changing their souls. He is not about turning average Joe’s into Donald Trumps, he is about correcting the course.
Matt,
I am in complete agreement with you. I think it is a significant problem when people attempt to be smarter than their money. Look, I have an MBA and just wrapped up seminary as well. I have a decent grasp on money and the bible and I think it wise not to try to be smarter than either of them. Ramsey makes it simple. Better to have a plan to get out of debt than to try to play with money and interest rates and save a bit here and there. The majority of people coming into contact with Dave and Financial Peace University are clueless about money. Dave’s process gives hope in a simple, yet difficult, process. When you’re upside down in debt get a plan and get moving. Dave encourages that. No need for people to keep judging the guy. He’s good at what he does. He helps many people. He’s been a part of changing my financial life as well as those of many people I know well.
What Dave does well is understands the emotional side of debt. Many people feel lost and overwhelmed. Gaining momentum is huge. Like any motivational theory worth its salt, the idea of creating a new history of small wins prepares someone for better attacking the big obstacles. I can pay off $1500 rather quickly, but $12,000 takes some time. I feel very little reward if I go straight at the big one. I may be less godly for having emotions, but I think it is important to gain some traction in order to carry better strength and resolve into attacking the big obstacles.
Dave’s approach may not be for everyone. If you’re out of debt, do whatever you want. If you’re over your head in debt and think you have a better process, go for it. If you succeed, write a book and get a radio show. Someone’s got to take over after Dave retires with all his cash. So, if your process is better. Honor God and teach others how you did it. I’ll not ramble any longer.
Keep in mind that at certain incomes, some people may fall into the AMT trap if they roll all kinds of debt into their HELOC. When calculating the AMT, you must add back any HELOC interest not used to improve your home.
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Adam, you are right about AMT. If you are near that threshold consult a tax adviser before following my suggestion.
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Great post.. ! I agree that we have to be more diligent with our personal finances when trying to reduce our debt. Paying off high interest cards before anything else is the best way to start. Thats how I paid of $30k in Credit card debt.
There are going to be things that some people disagree with when talking about anyone. Dave even says that on his radio show often… that he doesn’t expect you to agree with every single detail that he recommends. That is why he generally recommends that you seek counsel from an advisor “with the heart of a teacher” before moving forward with any investment decisions. Even then, he usually states that you shouldn’t invest in something just because Dave recommends it, or even because an advisor recommends it… rather, you should invest in it because you’ve done your research and believe in it.
I’ve gone through his FPU course, and also read his FPU book and TMMO book. With that said, I know I remember in FPU that your point of a 30-something investing only 15% is brought up. There is actually a form he uses, to recommend exactly how much you need to invest based on your age. The Baby Step 4 of 15% is a MINIMUM, but if starting at Age 50 you will obviously have to make more sacrifices in your lifestyle/budget to invest more money than a 25 year old would invest.
Great insightful post. However, just as I agree and disagree with things Dave says, the same also applies to your article. :-)
“If you are looking to get debt free, Dave is the way to go.”
… I agree; but what sort of goal is “being debt free” … surely that’s a means to an end?
If so, what’s the end?
Chances are the ‘the end’ involves more than being debt free; it involves having a certain passive income by a certain date.
And, chances also are that being totally debt free will be the best way to ensure that you NEVER make it.
Run the numbers on a spreadsheet …
AJC @ 7Million7Yearss last blog post..Rich Dad. Rich Kid?
BTW: the average return from the S&P 500 for ANY 30 year period is about 11.5% … with the worst 30 year period being 8.5% [source: Ibbotson as referenced by Paul Grangaard “The Grangaard Strategy”].
However, from this return you must subtract fees … it has been proven that funds tend to underperform ‘the market’ – long term – by the value of their fees.
And, the Dalbar Study shows that individual investors fare even worse because of their emotionally-driver trading strategies (typically making just 3% over the same period that the market returns >11%).
Ramsey’s notion of 10% – 12%, therefore, is rubbish; you should plan on the worst case 8.5% less the 0.15% Index Fund fee (Warren Buffett says to invest in anything other than a low cost index fund is lunacy, at least for the average investor).
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What Dave says about the snowball is just a general strategy, people are not smart with money, so he sets this general guideline that even he says you can tweak to some extent, the idea is to get you to start paying off your debt. if people knew about all these math problems to help pay off their debt they would be in debt in the first place and shouldn’t be listening to DR anyways because they are morons and don’t know how to stop paying with credit cards and financing cars and then wonder why they are 75,000 dollars in debt and get foreclosed on their home, etc etc. Write a book smart Alick!
OR YOU COULD BE LIKE ME AND HAVE NO MONEY AT ALL, THEN YOU WILL HAVE TO WORRY ABOUT LOADS AND MANAGEMENT FEES.
12% Mutual Funds after all fees as of 2/28/2011:
Heartland Value Plus Fund HRVIX 11.93 since 1993
Delafield Fund DEFIX 12.79 since 1993
New Perspective Fund ANWPX 12.53 since 1973
Fidelity Growth Company Fund FDGRX 12.99 since 1983
Fidelity Magellan Fund FMAGX 16.63 since 1963
These are just a few that I have found and there are several American Funds that fit the profile after fees.
True – there are many “actively” managed funds that have outperformed the “market” in the past but the question is which ones will outperform in the future. Morningstar has studies showing that investors have a better chance of success in the future if you sell the funds that have performed the best (four or five star funds) and purchase the ones that have underperformed (two or three star funds). From my experience, when investing keep it simple – buy the ASSET CLASS the cheapest way possible (index funds) – the ASSET CLASS provides the majority of the return.
I think one of the reasons Dave tells us to go after the smaller debt rather than the larger interest debt is due to confidence. If you have never paid off anything before, slaying a small giant goes a long way to tackling the next larger one. When I went back to college at 38 years old, I walked for my associates degree as a statement that I made it through the first part and I will make it through the second part, bachelors degree, which I did. I think it is more emotional based and not mathematical. You could become overwhelmed going after the largest giant first and just give up. It makes sense to get a win under your belt to gain confidence and to move forward with a larger hammer (debt snowball) for the next giant. My thoughts
I completely disagree with this article. My husband is in his 40’s and recently got a job making 70K/yr. We have run the numbers. He could still retire, not including the 401k, with a million dollars. If you listen to his show carefully on this subject, you can hear how he gets older Americans to a million dollar net worth in less than 2 decades oftentimes. Dave Ramsey represents hope and real results to many people who didn’t get great job that allowed the “$100/mo every month for 10 years.” That’s easy. Maneuvering people from any point in life to millionaire status takes skill, of Dave Ramsey is the master.
It is true that a HELOC has a tax deduction for interest paid. FEW people have an income that qualifies. Especially given the new standard deduction for Married Filing Jointly is 24,400 dollars. Most families do not pay 2000 dollars a month in interest. So they are taking the standard Deduction not itemizing.
But above that, borrowing money for a tax deduction is insanity. You are paying a bank 10K per year in interest on your home… in order to (Potentially – only if you itemize) deduct ~2000 dollars in tax liability.
Dave Ramsey has acknowledged numerous times that sometimes the debt snowball doesn’t always work out to be the best solution mathematically. But he is aiming for quick successes to help keep people on the path to zero debt. His research tells him that the debt snowball is the most effective way for people to stay focused. So I would say that if you know 100% you can stay focused, then go ahead and work that higher interest rate debt first. But Dave has also shown that the difference in savings between the two methods in many circumstances is not very great. Hence there is much more incentive for people to stick with the debt snowball than you think. It’s simply the method that gives the most people the most chance of getting safely home financially.