The Pros and Cons of Dave Ramsey’s Financial Advice
Dave Ramsey is an American financial guru, famous for his no-nonsense approach to personal finance and debt management. Dave runs a popular national radio show in which listeners call in with their problems, and Dave gives them advice drawing on the key points of his philosophy, the 7 baby steps to financial freedom.
These are as follows:
- Baby Step 1 – Save $1,000 to start an Emergency Fund
- Baby Step 2 – Pay off all debt using the Debt Snowball (tackle smallest debt first, up to the largest)
- Baby Step 3 – save 3 to 6 months of expenses in savings as an emergency fund
- Baby Step 4 – Invest 15% of household income into Roth IRAs and pre-tax retirement
- Baby Step 5 – Build college funding for children
- Baby Step 6 – Pay off your home early
- Baby Step 7 – Build wealth and give
Dave has also published several best-selling books and runs a course called Financial Peace University, which involves going through the baby steps in more detail.
Dave is an intelligent, charismatic guy, and there’s no doubt he’s helped countless people get out of financial trouble. But here we’ll take a look at the Pros and Cons of his strategy, and determine whether every aspect of his philosophy holds up to scrutiny.
- Value of an emergency fund
Dave is so dedicated to the concept of an emergency fund that he dedicates two of his baby steps to it. And with good reason. Saving up an initial $1000 not only gives a nice cushion for people if a boiler goes or the car needs some work, but it also starts people off with the habit of saving money. And it becomes addictive.Studies show that the majority of Americans could not find $2,000 if they desperately needed it. This fact means payday loans, overdrafts and credit cards turn into the only option for people when they face an emergency, which then only lead to more debt, more money owed and more problems.
Dave is absolutely right to stress that 3-6 months of savings is a key cornerstone of personal financial freedom.
- Debt = bad
Perhaps the most common theme on Dave’s radio show is the topic of debt. The Western world is in the midst of a credit crisis, a debt disaster that really damages lives. Americans are in nearly $4 trillion of consumer debt, with average car loan payment an incredible $523 per month, over a period of 5 years and 9 months.
Dave’s show is peppered with callers feeling trapped and drowning because of unmanageable debt. He stresses paying off all of your debt before you start saving (other than for the emergency fund) as not only is it mathematically sensible most of the time (because what you pay on interest rates eclipses what you can make if you save in terms of interest), but also because being debt free is a liberating feeling.
Debt can be a useful tool in very specific circumstances, and Dave concedes this – he recommends getting a mortgage, for example. But in the vast majority of cases, consumer debt is a bad thing – credit cards, payday loans, car leases, overdrafts – all of these things should be avoided if at all possible, and Dave is right about that.
- Allocate every dollar and budget
If you have a budget, you will spend less and spend more wisely. Dave’s company publish an app called EveryDollar – which allows you to draw up a monthly budget and allocate ‘every dollar’ to a purpose. There are countless other apps that do the same thing, and even a simple spreadsheet can do the trick.
Setting a budget does two things: it put any spending problems you have in black and white (‘I’m spending how much on Starbucks?’) and it objectifies and gives a grander purpose to every transaction you make. Your daily purchasing decisions will no longer be emotionally driven; you’ll be more likely to resist that morning coffee if you know at the end of the month you’ll see it in red in a spreadsheet column.
Dave’s insisting on maintaining a budget is well-founded advice.
The snowball method is an interesting one, as it’s both good and bad.
It’s a strategy for paying off your debts, from smallest to largest in value rather than by interest rate. So if you have a $500 debt at 2% interest, pay that off before you tackle the $5,000 debt at 3%. Dave insists on this strategy, as he cites the benefits of the psychological effect of knocking off a small debt outweighs the maths issue.
And in a way, he’s right. There’s a real cognitive boost in shedding a debtor, and the effect truly does snowball in that you’ll find yourself more motivated to knock the others off.
- Tax free savings
This one is a real no-brainer. Ramsey encourages everyone to take full advantage of tax-free savings accounts, and employer-matched pension accounts. Whether that’s a ROth IRA in America, or an ISA in the UK. These accounts mean you don’t pay any tax on interest earned, and if your employer offers a pension match, that’s a 100% return on your money straight away.
- Investing advice
Here’s where things start to unravel for Dave’s plan. Dave recommends investing in well-diversified Mutual Funds, comprised of a 4-fund mix of one growth fund, one growth and income fund, one aggressive growth fund, and one international fund.
Dave’s advocation of diversification here is wise, however where he gets it wrong is on the recommendation of Mutual Funds. A wealth of research on the matter shows that the vast majority of Mutual Funds fail to beat their respective indexes, and the average investor would be much better off investing in an Index Fund. For example, the majority of Mutual Funds that track the S&P 500 have failed to beat the returns of Vanguard’s standard S&P 500 fund over the past 30 years. When costs are taken into consideration (a fraction of a percent for Vanguard’s passive Index Fund compared to the 1-3% of most Mutual Funds) it really is a bad idea to go down the mutual fund route over the index route.
When confronted with this, Dave argues that Mutual Funds that have beat the index do exist, and that you should simply look at the track records and pick ones that have. This is neglecting the huge selection bias – the majority of Mutual Funds haven’t beaten the index, and many have failed, suggesting those that have beaten it have just been extremely lucky. Furthermore, Dave doesn’t seem to count the costs involved in his Mutual Funds, often citing the “12% average” his funds have gotten him, and dismissing the charges by saying “Well, you’d expect to pay for such good returns”, and never actually disclosing the charges themselves.
Dave’s company, Ramsey Solutions, have a team of endorsed ‘Smartvestor Pros’ that advocate Mutual Funds he is affiliated with, earning him large commissions on any referrals.
- Aggressive house payments
Dave recommends paying down your house as quickly as possible, and says you should never get more than a 15 year mortgage. Whilst true that you’ll pay far less interest over a 15 year period than a 30 year period, obtaining a 15 year mortgage is simply unaffordable month-by-month for most people.
- Snowball isn’t technically the best
As alluded to above, whilst the snowball method has many benefits psychologically, mathematically it doesn’t always add up. In some cases, a larger debt may have a ludicrous interest rate, in which case you’re much better off paying off the larger loan first.
- Political bias
Dave is unapologetic about his hatred for Government interference with most matters, and wears his conservative tendencies on his sleeve. This wouldn’t be an issue in and of itself, however it seeps into his advice at times. Dave enjoys pouring scorn on research done by the more left-leaning media that claims the average American is worse off, by citing things like the fact there are more millionaires in America each year, or that the majority of them are self made. Whilst these things are true, Dave is ignorant to the fact that for the average American, things have gotten harder, and they are worse off in terms of cost-of-living.
Dave believes that anyone has it within themselves to become a millionaire, no matter what their situation. Whilst it’s admirable in one sense to believe this and give people hope, the reality is a lot less straightforward, and Dave can be quite scornful and insulting in his dismissal of people who don’t agree with him on this.
- Religious influence
Dave’s shows are punctuated with Biblical references and proverbs, most of which are fine and can offer some neat little advice. However, Dave’s insistence on the fact that all of his principles and in fact everything you need to know about life, can be found in the Bible, can be a little jarring to the… less spiritually inclined listener.
Though be fair to Dave, he never gets upset at the non-religious listeners, and certainly doesn’t discriminate.
All-in-all, despite the shortcomings in the details of his investment tips, Dave Ramsey offers excellent advice to the average person. Avoiding debt as much as possible, building a strong emergency fund, setting a budget and saving money are sound if simple principles to live your life by.
Dave’s book, The Total Money Makeover, is available here from Amazon.