I consider myself financially savvy. I participate in the company 401(k) plan with match, max out my Roth IRA, saved well over six months of emergency living expenses, and have no credit card debt. I have a car loan and student loans and rent (because housing prices are too expensive in California).
However, over the past few weeks, I’ve been listening to the Dave Ramsey radio show on XM on the commute home and have been questioning my personal finance strategies. Dave’s strategies include a seven step process to financial peace:
- $1,000 to start an Emergency Fund
- Pay off all debt using the Debt Snowball
- 3 to 6 months of expenses in savings
- Invest 15% of household income into Roth IRAs and pre-tax retirement
- College funding for children
- Pay off home early
- Build wealth and give!
From the few weeks I’ve spent listening to his radio show, I’ve determined that his foundation is to eliminate all forms of financial leverage, or simply, debt. Being a trained economist and avid reader of business and personal finance books, I’ve been led to believe that debt is a powerful tool for using “other people’s money” (OPM) to achieve one’s goals. To pay for college, I took out a few low interest loans. To buy my car, I took out a bank loan. To pay for daily expenses, I paid with credit cards (and paid the balance off monthly).
While in theory, using debt can be advantageous, particularly if you can borrow at an interest rate lower than what you can earn investing the money, it doesn’t factor in the human component and risk. Debt is inherently risky, hence the need to apply interest rates depending on the risk levels. If these large multi-national firms, such as Bear Sterns and Fannie Mae and Freddie Mac, are going under due to poor debt and risk management, what makes you believe you can do better without an army of accountants and lawyers on your side.
If you have to take a loan to buy something, you can’t afford it
Car Loan – It does not make sense to use debt to pay for a depreciating asset. In other words, you are paying the bank or the car dealer, for a car that loses value year-over-year. After I pay off my loan, I’m keeping the car forever. Paying $400 to fix a radiator is always a better choice than paying $20,000 for a new car to replace the junker. Keeping your current car is always a smarter choice than buying the latest hybrid to save on gas prices.
Student Loans – While most financial planners and schools say that student loans is an investment in your future, it is only so if you are in a field that can generate a positive rate of return. If you have to take out massive loans to attend a private school and cannot get enough scholarships, then you can’t afford it. I wish someone told me this before I took out my loans. Instead, I’m paying monthly payments for the next 10 years.
Mortgage – Everywhere I read and everyone always says that your house is the best investment you can make. Is it true, or is the housing industry that powerful, like DeBeers with the diamond industry? People say that buying a home is a good choice because you get to write off the tax.
Let’s say you pay $10,000 per year in interest payments to the bank (which is realistic during the first years of the mortgage). Additionally, assume you make $70,000 annually. If you use the tax write off, you would pay taxes on $60,000 of your earnings ($70,000 less $10,000). At the marginal tax rate of 25%, you would “save” $2,500. Put it another way, you paid $10,000 to a financial institution to save $2,500.
Sure, the “housing prices always go up.” During this mortgage crisis, a lot of people are finding out that housing is like an investment. It goes up and down. Unlike stocks, you cannot buy and sell as easily. The transaction costs (broker, agent, closing costs) wipe out any profits and add to loses.
Having no debt is a great way to become wealthy
While economically, it makes sense to keep debt that is low interest, such as a low interest student loan or a 0% interest credit card, emotionally, it does not. From month to month, those debt payments are painful. It gives you a sense of poverty or that you’re enslaved to the creditors. As such, you spend more to feel better and save less because you feel like you have less.
In step 2, “pay off all debt using the snow ball method,” Dave recommends writing down all loans and arrange in order of smallest balance to largest. Pay the minimum balance on all loans, and pay as much as you possibly can on the smallest debt. Once the smallest debt is paid off, start paying the next one, and so on. Using this technique, you get “small wins” and feel like you’re making progress in eliminating debt.
Furthermore, Dave recommends really attacking the debt. He says that you should live on rice and beans, and consider taking on a second job to generate more income.
So what’s the right answer?
Having spent a good part of a summer sitting at Barnes and Noble’s business section and reading all types of personal finance and investment books, I am now officially confused. What’s the right answer? Mathematically, I know what the right answer is. Add in the human factor, and the equation gets really confusing.