By Adam Jusko, ProudMoney.com, adam@proudmoney.com
Dave Ramsey is a popular personal finance writer/broadcaster with a loyal fanbase. I suspect his fans are so loyal because Ramsey says just about everything with supreme confidence, as if no sensible person could have a different opinion. When people are feeling lost, whether financially or otherwise, a strong personality with strong opinions may feel like a godsend.
This is not to bad-mouth Ramsey. Much of what he says is good, common sense. But not everything. And I believe it’s good to question Ramsey’s guidance just the same as you would question anyone else. Like most who give you advice, Ramsey wants to make a buck off of you, as you’ll notice from the astounding number of info products he’s hawking on his website and how often he pushes you to buy.
So lets look at Dave Ramsey’s 7 Baby Steps to Financial Peace, a checklist for people trying to get their financial lives together — one “baby step” at a time. I’ll look at where Ramsey makes sense, and where he simply has a strong opinion that many other financial experts would disagree with. Let’s go step by step…
Baby Step 1: $1,000 cash in a beginner emergency fund
It’s a sickening feeling when it seems you are just barely getting by and then an unexpected expense comes up. Where are you going to get that money for a car repair, appliance breakdown, emergency room visit, etc., when you can barely meet your expected expenses?
The key, then, is to plan ahead, to do whatever it takes to rustle up $1000 to put into a separate account that you only touch in true emergencies. To do this, you’ll need to examine where every dollar is going and siphon away a few bucks each month to build this fund. Or, do something to earn more temporarily, whether that’s taking on an outside project, starting a side hustle, or selling some of your stuff.
This is no-brainer good advice. The obvious first “baby step” in your financial life should be to build some sort of cushion so you do not plunge into complete desperation when faced with an unexpected expense (which you might as well think of as an expected expense because something always eventually goes wrong, you just don’t know what it will be).
Baby Step 2: Use the debt snowball to pay off all your debt but the house
Getting rid of debt is also a no-brainer. When you pay interest, you’re essentially paying extra for every product and service you use, meaning you’re effectively paying more for the same stuff than other people who don’t carry debt.
Ramsey suggests you use the “debt snowball” method to cut your debt, which means you pick off the smallest debt first, pay it off, then move on to the next, which creates a “snowball” effect in terms of your motivation. Each debt erased enhances your motivation to tackle the next.
While this makes psychological sense, it does NOT make mathematical sense. You will pay more in interest when choosing the debt snowball method! Why? Because you may be paying off debt with a lower interest rate before debt with a higher interest rate! Credit cards have much higher interest rates than car loans or student loans, so credit cards should be paid first, especially if the balance on credit cards is higher than the car loan or student loan.
Say you have a car loan that you owe another $4000 on, and the interest rate is 5%. Now, say that you have $7000 in credit card debt, all at an interest rate of 15% or more. It makes no sense to concentrate on paying off your car loan early when you have all of that high-interest credit card debt. Simply put, you are paying more.
If you have some small debts under $500 at low interest rates that you’d like to “snowball” in order to cut down on the number of bills you have, go for it. Otherwise, though, throw out this debt-reduction advice.
Baby Step 3: A fully funded emergency fund of 3 to 6 months of expenses
No quibble with this one. Having money that you can easily access due to job loss, medical emergency, etc., is just smart, especially if peace of mind is your goal. I’d say if you can get to three months of expenses saved, you’re free to move on to other goals. To me, six months’ worth of expenses is overkill.
Baby Step 4: Invest 15% of your household income into retirement
Obviously you should save for retirement. If you can do 15%, great. If not, do something. If you can do more, even better.
Now here is where I and most other financial journalists will strongly disagree with Ramsey. He suggests spreading your money across four types of mutual funds: growth, aggressive growth, growth and income, and international. And he advocates for a more “active” investing strategy that has proven to cost you more without giving you any more in returns. Because part of the Ramsey money-making machine is to get you to use one of the Ramsey-affiliated financial advisors, it makes sense that Ramsey encourages this strategy — it makes his company money!
A better strategy: Put 75% of that retirement money into an S&P 500 index fund, especially when you’re taking your first “baby steps” into retirement investing, because that S&P fund is likely to do just as well as those other funds, and do so with lower fees. It’s very possible that the difference in fees could be 1% or more when you are invested in actively-managed funds vs. index funds (which are easier and cheaper for companies like Vanguard and Fidelity to administer).
If you want to take the remaining 25% and invest in a more aggressive “growth” fund, go for it, but be aware that the growth fund may need to outperform the index fund by 1% or more in order to really be giving you any upside. (Note that if you are saving through a company-sponsored retirement plan, your choices of investments may be limited. Grab those low-fee index funds if they are available.)
Baby Step 5: Start saving for college
This assumes you have children, obviously. Ramsey suggests that once you’re saving that 15% for retirement, you should be putting money into a 529 plan or Coverdell ESA (Education Savings Account), both of which give tax advantages as long as that money is eventually used for school expenses. In my house, we save into a 529.
I agree with Ramsey here, but many people don’t. In fact, I am surprised at the number of couples I know who make decent incomes and say they don’t plan to save anything for their kids’ college education — anything extra goes into retirement instead. I’m all for securing your retirement, but personally feel that saving for at least part of my kids’ education is one of my responsibilities as a parent. Study after study shows how much more the average college-educated person makes in comparison to those without a degree, and I’d rather not see my kids sink into terrible debt to get there. I believe you should strike a balance between retirement savings and college savings if you are fortunate enough to have the extra money to make that choice.
Baby Step 6: Pay off your home early
Throw this one out, it’s terrible advice for most people, especially those taking financial “baby steps.” At least Ramsey lists this after the others, so he’s not suggesting you make it a priority.
If you own a home, there is a good chance that you have a mortgage interest rate of 5% or less. Historically you can earn much more than that investing in the stock market. Depending on how you slice it (in terms of which years you use as start and end points), the stock market gives an average of at least 7% but possibly more over the 30-year stretch that a mortgage normally lasts.
Put your extra money into your retirement accounts, not into paying off your house early, unless you’ve received some huge windfall and have lots of extra money lying around. Not only do you get a better return, but your money grows tax-free in the retirement account.
In addition, paying off your mortgage means that a very large chunk of your net worth is tied up in your home, maybe more than half of all your money. If you end up needing more money in the future than you have in your emergency savings, you’d be forced to take a home equity loan to tap into the money invested in your home — or sell your home altogether. Better to keep more of your money “liquid” and easier to access if needed.
Baby Step 7: Build wealth and give generously
OK, duh. Hard to argue with getting wealthy and giving to causes you care about.
My Advice: Shed High-Interest Debt, but Don’t Make All Debt the Enemy
Dave Ramsey is a rabid anti-debt financial advisor. But he oversimplifies by treating all debt as if it is the same. Paying 20% interest on your credit cards is a dumb thing to do. Paying 5% on a 30-year, fixed-rate mortgage is not dumb at all, especially when you can earn more than 5% in the stock market on average and your home is very likely to increase in value.
Ramsey simplifies in the interest of having a consistent message. He assumes that the simpler he keeps things, the more likely it is that people will do at least something right. And that’s not a terrible strategy. If you are someone who has made bad financial decisions in the past or who feels totally lost financially, following his advice to the letter might be right for you. But if you are a little more sophisticated about finances or are willing to learn, some of Ramsey’s advice can safely be kicked to the curb.