So I kind of have touched on this topic before but a recent experience made me rethink a few things I knew about money management and wanted to share this experience and takeaways with you.
If you’re not familiar with him, Dave Ramsey is a fitness coach. His slogan is more or less along the line of: never be in debt again so you can start building your wealth. He wrote a book “The Total Money Makeover” has a podcast and is pretty popular among individuals who are trying to get their financial home in order. If you haven’t listened or read any of his material, here is his step by step plan to building wealth:
1. Create an Emergency fund of $1000
2. Pay off your debts from smallest amount to largest with the exception of your home
3. Build a savings amount of 3-6 months worth of expenses
4. Invest 15% of income into retirement
5. Build your children’s college fund
6. Pay off your home early
7. Build wealth and give
A lot of his ideals are common sense advice. However here’s a few things his approach doesn’t account for
1. His approach assumes you already own many of the things you need (home, vehicle, job). I’ll touch more on this below
2. Paying off your debts from smallest to largest doesn’t necessarily free up the most amount of cash to apply towards your next loan or to save. There are other methods (that I’ll explain more below) that can also help you get out of debt rather than paying off from smallest to largest
3. Putting off saving while you’re paying off your debts is exponentially dangerous especially when we’re talking about compounding interest for retirement or college savings. (Again I’ll explain this in detail below)
So within the last year I moved back home. Following Ramsey’s plan my goal was to pay off enough loans so that I could move out on my own and be debt free. However I recently had to make a big purchase. I did the math on how much I could afford in monthly payments while also still being able to save and make payments towards my debts. I eventually want to purchase a home so I want to make sure I can still save in the meanwhile to put a down payment on a house. I’m adding another debt but I’m confident I’ll have it paid off in a little over a year while still being able to make progress towards my goal of owning a home. Ramsey’s approach says nothing about this kind of money management. He screams pay off loans, pay everything in cash and build wealth. Well that’s fine and dandy if you already have a home or a reliable vehicle and a steady job. I have a steady job, but I do need to save RIGHT NOW to be able to have my own home because even if I put all that’s left over from my paycheck towards my student loans (which prior to this purchase were my only debt) it would still take me over a year and a half to pay them off while leaving me with no savings and very vulnerable at the end of those 18 months. So paying everything in cash is great but I would have had to wait 18 months just to start SAVING to make this purchase and I’m 100% confident I would not have been able to reliably and safely get to work without this purchase.
On to my next point. Paying off your debts from smallest to largest makes sense except for when it doesn’t. When I started listing my debts from smallest to largest it was clear that my credit card needed to be paid off first, then my Perkins loan and then attack my Stafford loan with voraciousness. However I already mentioned that I’m trying to SAVE money, by paying off my credit card first I only freed up $15 monthly. If I had paid off my Perkins loan first I would have freed up $40 every month that could go towards a different debt or towards savings. The approach is the cash flow index. It takes into account the interest rate, the total amount owed, your monthly payment and gives you a number that helps you determine which will free up the most cash quickly. This guy explains it better than I do: http://www.huffingtonpost.com/garrett-b-gunderson/rocket-scientist-invents-_b_6517006.html
Going forward this is the approach I’m using.
Finally my third point, Ramsey advises to stop investing into your retirement account until you have paid off all your debts. How long will that be? A year, two, three, ten? Those are years where your retirement account could be gaining interest and you can’t get those years back. If you were paying attention in math class, the amount in the account will compound over time and will yield a lot higher return later than putting more into your retirement account years later. Essentially it will take a lot more than 15% to catch to your peers who’ve been saving up for years before you.
My advice, (although disclaimer here I clearly am no expert) is to not follow his approach (or any “fitness coach”) blindly. You’re a smart cookie. Do some research, live beneath your means, watch your spending habits (I like Mint.com) and make A PLAN for what you’re money is going to be doing for you and where you plan to be in 5,10, 20 years.
I made a big purchase, but I carefully planned and estimated how much I’ll saving for a down payment for a house while I’m paying it off, how much time it will take me to pay off my student loans and I have a plan for how I’m going to be able to save enough for other purchases I’ll eventually have (son’s extracurricular activities, before and after school care, son’s college, etc). I’m not a slave to the Dave Ramsey approach but I’m confident about where my financial house stands.