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Debt in General and then a little Dave Ramsey

December 8th, 2008 at 06:15 pm

I thought I would just comment on debt in general and then Dave Ramsey and his steps.

Debt is neither inherently evil nor good. It is just a financial tool, but it is a double edged sword and can cut both ways. Many people view a student loan as good debt.

In some cases, it is not. If I borrow $60k for college and come out making $30k a year was it worth it? This is the risk aspect. In essence, when you are taking on student loan debt, you are betting that your future earnings will greatly exceed the debt.

If you were laid off or unemployed, you would still need to service your debt. This is where the risk really becomes evident. You took a loan that must be repaid for a better job that you are unable to get. (With hardship deferrals, this might not be the greatest example but I think you get my general point.)

With debt, you also need a larger emergency fund. You need enough to pay the minimums and your other expenses. In my case, last year, I was paying about $1,700 a month to service debt on medical, cars, and braces. For a six month emergency fund, I would need to have an additional $10k just to stay current on the debt. If I were to add in my mortgage of $2,042, the emergency fund goes up another $12,252. So, my example, over $22k of my 6 month emergency fund is just to service debt.

What do I truly need to survive? Food, utilities, transportation, insurance (health at least) – total cost might be $2,500. Or a $15,000 emergency fund. Or about 60% of my emergency fund is used towards servicing debt.

The interest on the above debt ranged from 0% - 4%. In fact, the highest interest rate I paid this year was 5.5% on my mortgage. Some people would say well you could invest that and beat what you are paying on the interest.

Also, this year might be a good example where it would have been hard to beat 4%. Sure, this year might be an anomaly, but my point is that you can't guarantee that you can beat the interest on your debt.

More importantly, I didn't have the money at that time. And that is the real reason for the debt, and I suspect this is the reason that most people go into debt in the first place. In my opinion, the whole investing and taking out debt argument is a way for most people to rationalize the debt.

Switching gears and looking at Dave Ramsey. I believe his true goal is to free up your cash flow as quickly as possible and use that towards wealth building. With that in mind, the issue I have with Dave Ramsey is that he is short on investment advice. His goal, I believe, is to bring you to a spot where you can start building wealth.

If you look at his first three goals, they are really to set up an emergency fund and pay off all your "small debts" (everything but the big mortgage or big second mortgage). His argument is that in the long run, it doesn't matter if you miss a year or 2 of saving for retirement or college for the kids.

His other point is that when we are first starting this journey, most of us don't have enough extra at the end of the month to do everything – save for an EF, pay of debt, save for retirement, save for college, invest. So, his method is a path that helps people focus their resources and quickly move to free up cash flow.

Personally, I have been paying debt and maxing my 401(k) contribution. In retrospect, I would have been debt free at the end of September and had an additional 3 month of EF saved. In hindsight, I probably would have been better off following Dave Ramsey's advice. I definitely would have had less stress.

And next year, I will be attacking 3 goals at the same time – EF, 15% to retirement, and college funding. I will be doing these all at the same time as well. By the end of 2009, I'll be in the same please regardless of which way I went, but I do think following Dave Ramsey's plan would have reduced my stress further.

Dave Ramsey also makes some exceptions to his rules that I think are good. If you are in danger of being laid off or your wife is expecting, stop paying off debt and start saving everything. Once these events past, throw everything saved at debt and then proceed.

So to sum up this rambling, debt is neither bad nor good. It is merely a tool. The real issue is how we use it. In the example of student loans, is it a way to increase our earnings at a reasonable cost?

Do we really do an analysis on how we use debt? Do we look at risk and added stress, opportunity costs, and the future payoffs of our decisions now?

For most of us, we use debt to fund a want we want now. We buy cars by looking at the monthly payment without thinking about what we are giving up by making this choice. We fund things on credit cards and carry balances month to month, wasting money on fees and high interest rates.

As for houses and student loans, the issue is that you don't want these debts to be a burden and you need to look carefully at these debts.

As for Dave Ramsey, I think that his steps of budgeting, eliminating debt, and savings for college and retirement are pretty solid. He gives you a step by step approach on how to focus and gives you tool that help you see quick progress.

Some people say to pay off the highest interest rate first. Mathematically, it does make sense. In truth though, you might save a few months. If you look at your credit cards which probably have the smallest balances and the highest rates, you might have a difference of 5% per card which is about 0.4% monthly difference. If you have zero percent and 30%, the interest difference per month would be 2.5%, which I think would be the most extreme case.

But you need to also take into account what your goals are. Are you welling to give up your life in the short term to pay off debt or would you rather slowly pay off your debt and enjoy more of your life?

For the first, Dave Ramsey's plan works. For the later, you are better off saving a little for retirement and building an EF.

The real issue and the end of the day is: What are your goals?

10 Responses to “Debt in General and then a little Dave Ramsey ”

  1. jIM_Ohio Says:

    DR's advice is short sighted from where I sit.

    You hit it directly- good for getting out of debt, then falls short in investments. You left off taxes as well- DR's advice is not tax advice, and that needs to be part of whole picture too. He also does not apply a timeline to his advice. A timeline would introduce inflation and compounding into more aspects of the situation.

    If you do not save and can wipe out debt in X months (less than 36) maybe it was good idea to not invest.

    If you save and wipe out debt in X+36 months it was clearly a better choice because the investing had a company match and compounded over 72 months.

    Without the time aspect of measurement, the two situations could not be compared.

  2. merch Says:

    From what I know, DR suggests 24 months being the timeframe for debt free (minus house) and fully funded EF.

    Chances are most people are nto maxing their 401(k) contributions so the tax savings over 2 years may be negligible when compared to the interest being charges for the outstanding debt.

    But you are right, he's not a CPA. And his advice could have cost be on the medical deduction for my son.

  3. ceejay74 Says:

    Thanks merch, nice counterpoint to the recent discussion. I can see both POVs.

    See my recent post to check out how much of my EF amount is to cover minimum debt payments. Yowch!

  4. Petunia Says:

    Well said Merch.

  5. scfr Says:

    I'm one who is neither a Dave Ramsey devotee or basher. When I first heard about him, I thought he had a lot of good things to say, but I also knew his advice wasn't for me since I had no debt.

    I try to keep an open mind.

    I was thinking about Dave Ramsey and the whole "pay off the high interest rate card or pay off the lowest balance" question. So many of us say ... why, of course the highest rate card should get paid off first, because that is the most logical. But the fact is that it is not logical to get in to debt in the first place. Perhaps getting in to debt is driven by emotional reasons (the exception being the 22yo who is fresh out of college and gets hit with major medical expenses and has no insurance ... I'm not talking about that kind of person ... I'm talking about the average "I'm in debt because I like to buy stuff" person). Maybe Dave Ramsey understands that people who are likely to end up in debt in the first place are the types that will benefit emotionally from paying off a smaller balance first and seeing it disappear entirely? Perhaps he has come up with the plan that works best for his target audience?

  6. baselle Says:

    Excellent points - many times we are stymied by the labels "good debt" and "bad debt" when in fact the labels should be "necessary debt" and "unnecessary debt" or "risky debt" and "not risky debt".

    If you are the type to accumulate unnecessary, risky debt, perhaps DR is suited to you. If your debt is necessary and not risky, DR's one-size-fits-all will probably piss you off.

  7. Apprentice Fun-Frugalist Says:

    Great point scfr about the emotional mini "victory" of paying off smaller debts to spur you on to tackle large ones. Emotions are fundamental to getting into/ out of debt.

  8. Broken Arrow Says:

    Dave Ramsey is a hot button topic pretty much anywhere you go. Believe it or not, I like Dave Ramsey and have recommended him to others before, depending on their needs.

    I know I've said this before, but the one thing that really does chafe me are some of his zealous devotees that insist you MUST pay the low balance. High interest isn't even an option. You MUST NOT have a credit card. All credit cards are evil. You MUST pay off all of your debts. At once. There is no other way (except mortgage).

    I could be wrong, but it seems as though people like that have only read one book from Dave Ramsey (the Total Money Makeover it seems), and perhaps listened to a few of his shows. And suddenly, they believe they have transcended to the status of "Guru" because, wow, this stuff is so easy! I grasped it so quickly, so therefore, I must be like a financial genius or something, ready to change the world to my enlightened way of thinking! I'll even start my own blog or website so that others may make their pilgrimage towards my mecca, ready to submit to their new prophet and seek financial salvation!

    And anybody who disagrees with me is wrong, I tell you! They're unwashed heathens. Foolish mortals who will lead you astray from the path of the self-righteous I mean righteous.

    THAT kind of attitude is what bothers me.

  9. Aleta Says:

    Oh BA: We would never disagree with you most knowledgeable one. Just kidding.

    I have a family member that was throwing money to savings, to ALL of her debts, and was really becoming frustrated because she couldn't see any process.

    I personally didn't follow the Dave Ramsey Plan, but I did follow a plan that set up a budget that had categories that I never had before. Even though we were contributing small amounts, we were building towards accounts that would in time would be there when we needed them. For us, it was putting $5. a week in savings in the beginning. This man felt like it was very important to get into the habit of having these accounts early on. By the time we were out of debt, it was like 2nd nature to me and more money then to add to the savings or to shore up other accounts.

    Keeping someone focused on one issue at a time has more of a chance of succeeding. As we were going along, we were knocking out one debt at a time and it was a great feeling. I would reward myself with a small item. It could have been a book that I wanted. It need not be an expensive item. I still have these books. I wrote in a few of them which bill we paid off when we bought the particular book. You need to see progress. That's important.

    Like you, i see Dave Ramsey as trying to get you into cash flow mode so that you can acquire more wealth. When you have cash flow you have more choices.

  10. Broken Arrow Says:

    Oops. I just realized that my wording could have been misread as me acting like a know-it-all. I'm not going to lie, I do act a know-it-all. I know I don't everything, but I suppose coming across like one is a personality flaw that's still a "work in progress".

    Anyway, it's other people who really believe that that chafes me.

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