If you have a few minutes, watch this slide show from Dave Ramsey: Drive Free. Retire Rich.
According to the video, a third of car buyers finance their cars for 6 years at 9.6% interest, making their monthly payment about $475.
He then presents an idea…
You want a new car. Your current car is worth $1,500. Instead of spending $475 per month on a new car note, why not save that car note amount for 10 months and add that $4,750 to your $1,500 car and buy a $6,250 car?
Of course, this requires some assumptions:
1. That your current $1,500 car can hold out for 10 months.
2. That you’ll be able to get $1,500 for your old car.
Assuming that both assumptions work out, you’ll be driving a $6,250 car that you don’t owe any money on.
The illustration then assumes that you continue to save your $475 for the next 10 months. At that point, you take your $4,750 in savings, add it to your $6,250 car (that hasn’t depreciated, btw), and purchase an $11,000 car.
So far I like the idea. It’s past this point where Dave loses me.
Because he starts talking about investing that $475 into a mutual fund that earns a “stock market average of 12%.” YEAH! TWELVE PERCENT! This is just wrong on two fronts:
1. Where you going to find a mutual fund that earns 12% in this environment? I’m not saying that a mutual fund can’t earn 12% but where does one find such a fund?
2. There’s a HUGE different between a stock market average return and an actual (geometric) return. Using a linear 12% annual rate of return on a monthly basis, overstates the actual return.
I would have respected Dave had he used the return for the S&P 500 Index rather than just some number he pulled out of thin air. According to my numbers, the geometric average return for the S&P 500 Index (going back to 1926) is .76% per month. Subtracting off .02% for expenses, we get .74% per month. That’s a far cry from the 1% per month Ramsey assumes in his illustration.
How much difference does it make? A lot. Here’s a nice little graphic for comparison’s sake (assuming a return of .74% per month and NOTHING taken out for future car purchases):
The Bottom Line…
Ramsey’s plan isn’t necessarily bad. I just don’t understand why he feels the need to use such a high expected rate of return. It seems to be a disservice to his followers because it’s not based in any sort of reality.
I think Dave should stick to his “get out of credit debt” message and leave the investment stuff to people who know what they are talking about.