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Before you follow Dave Ramsey’s advice, see what economists think you should do instead.
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When it comes to personal finance advice, there aren’t many people more famous than Dave Ramsey. His radio show is in the top 20 in terms of popularity, according to YouGovAmerica. That’s for all types of radio shows, too, not just personal finance. He has also written multiple bestsellers.
But just because someone’s popular doesn’t mean you should blindly follow their advice. Some of Ramsey’s money rules aren’t necessarily the best approach for everyone, and can go against what economists would recommend. Here are three areas where economists disagree with Ramsey, based on information from a research paper by James J. Choi, professor of finance at Yale University.
1. Pay off your debt with the smallest balance first
Ramsey recommends using the debt snowball method to pay off debt, where you prioritize accounts with smaller balances. Here’s the step-by-step process provided on his website:
List your debts from smallest to largest.Make minimum payments on all debts except the smallest.Pay as much as possible on your smallest debt.Repeat until each debt is paid in full.
Economists, meanwhile, recommend that you prioritize your highest-interest debt. This is known as the debt avalanche method. You’d follow the same steps outlined above, except instead of paying as much as possible on your smallest debt, you’d pay as much as possible on your debt with the highest interest rate.
In terms of efficiency, Ramsey’s method doesn’t make sense here. The debt avalanche is faster and saves you more money on interest than the debt snowball. To demonstrate that, let’s say you have the following on your credit cards:
A $1,000 balance with an 18% APR and a $30 minimum paymentA $4,000 balance with a 20% APR and a $110 minimum paymentA $10,000 balance with a 24% APR and a $300 minimum payment
Let’s also assume you can pay a total of $500 per month toward your debt. Here’s how your results would compare using each debt repayment method:
By prioritizing your highest-interest debt, you’d save $376 and get out of debt a month earlier. So, why is Ramsey so adamant about the debt snowball? As he puts it, “debt isn’t a math problem, it’s a behavior problem.”
Ramsey believes the key to eliminating debt is changing your financial behaviors, and you’re a lot more likely to do that when you see results. With the debt snowball method, you get your first “win” (paying off an account) as quickly as possible. That could help you stay motivated in a way you wouldn’t using the debt avalanche.
Both methods have their advantages, and there’s no right or wrong option for every single person. The best method to pay off debt is the one you can stick to until your debt is gone. Choose either the debt snowball or the debt avalanche, depending on which one you like, but follow the plan until you’re debt-free.
2. Get a fixed-rate mortgage
When buying a home, Ramsey advises his audience to get a fixed-rate mortgage. He recommends this option because your interest rate will be locked in for the life of your mortgage, so you don’t need to worry if interest rates increase. Ramsey’s not a fan of adjustable-rate mortgages (ARMs), and an article on his site even calls them a “terrible idea.”
Anyone who remembers the financial crisis from 2007 to 2009 probably has an idea of the dangers of ARMs. Your interest rate can increase with this type of mortgage, making it more expensive. If your monthly payments go up and you can’t afford them, you’re at risk of defaulting.
You might be surprised to learn that economists recommend getting an ARM unless interest rates are low. Here are the reasons why:
ARMs normally have lower interest rates than fixed-rate mortgages.That’s because interest rates on ARMs are pegged to short-term interest rates. Interest rates on fixed-rate mortgages are pegged to long-term interest rates and have a premium.Short-term interest rates tend to fall more than long-term interest rates during a recession.If interest rates fall, interest rates for ARMs will decrease on their own. Borrowers with fixed-rate mortgages would need to refinance to get a lower interest rate in this situation.
A fixed-rate mortgage is safer in the sense you don’t need to worry about your interest rate and monthly payment going up. But Ramsey’s warning about ARMs is, like much of his advice, too extreme and one-size-fits-all.
If interest rates are low, then locking in a fixed-rate mortgage is a great idea. But if interest rates are high, like they are right now, consider following economists’ advice to get an ARM.
With an ARM, you’ll start off with a lower interest rate than you would’ve gotten from a fixed-rate mortgage. The tradeoff is that if interest rates rise, so will the rate on your ARM, which wouldn’t be the case if you had a fixed rate. But there are a few things to mention about this:
The interest rate on an ARM is locked for an initial period of time. This depends on your mortgage, but five, seven, and 10 years are all common options.After that initial period, the interest rate on an ARM can normally only be adjusted once per year.ARMs usually have both yearly and lifetime adjustment caps.
3. Put 15% of your income toward retirement
Ramsey has a money management system called the “7 Baby Steps.” Under this system, you start by focusing on your emergency fund and all non-mortgage debt. Once you’ve paid off all non-mortgage debt and saved three to six months of living expenses in your emergency fund, you start investing 15% of your income toward retirement. That’s his advice regardless of your age and income.
Economists recommend something entirely different called consumption smoothing. That refers to adjusting your savings rate and spending over time to optimize your quality of life.
Here’s the part that surprises a lot of people: Economists generally recommend a low or even negative savings rate while you’re young. Yes, that could mean taking on debt as a young adult. Economists recommend a high savings rate in midlife.
Their logic is that young adults often don’t make much money, so trying to stay debt-free and invest 15% of your income could negatively impact your quality of life. By midlife, you should have a much higher income, so a savings rate of 15% or more will be much easier to handle. With this approach, you’re effectively trying to maintain a reasonable standard of living throughout your adult life, instead of suffering while you’re young to have more money saved later.
The big problem with the economists’ advice is that financial habits can be hard to break. It’s not easy to go from spending all your money to saving and investing a portion of it. Even for young adults without much extra money, it’s a good idea to save at least a small amount of it. You can still use most of your money to lead an enjoyable life. Just set aside some of your income to save and/or invest every month. The amount you choose is up to you.
Do what works best for you
Ramsey and economists don’t always see eye to eye, but they each make valid points. That’s why it’s important to compare advice from multiple sources for big decisions. You can compare arguments and figure out which option is best for you.
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