I have never counted myself among the Dave Ramsey fans. Sure, his advice is better than racking up lots of debt and not saving for the future. But, he also generalizes and has a one-size-fits-all approach to the advice he offers his listeners.

What bugs me most is the math behind his assumptions.

For example…

On page 3 of the above-mentioned workbook, is this:

“The American Dream

Imagine if…
A 30-year old couple made $48,000 a year and saved 15% ($7,200 per year or $600 per month) in a 401(k) at 12% growth.

At 70 years old, they will have…
$7,058,863.50 in the 401(k)”

How did Dave arrive at that number? Here’s the math:

That’s a lot of money!

But, how would this look in the real world? I summarized Dave’s information into the following graphic and used 2009″s numbers from the IRS to calculate income taxes.

For my example, I assumed that this couple does not have children. If that were the case, it would probably be possible for them to sock away $7,200 per year. Their budget would be tight unless they economized.

Then comes my next question:

WHERE ARE THEY GOING TO GET A 12% RATE OF RETURN FOR 40 YEARS?

Seriously, WHO assumes a 12% rate of return for 40 years? Later on in the book, Dave stresses diversification. There’s not a properly diversified portfolio on earth that is going to average a 12% rate of return on a consistent basis. The ONLY way you’re going to get that kind of return is to invest ALL YOUR MONEY in small cap stocks, which are highly volatile.

I think the word “imagine” was the proper word to use for his scenario because the only way he’s going to get those numbers is with IMAGINATION!

To bring us back to REALITY, I reran Dave’s numbers using a much more conservative .77% monthly rate of return, which happens to be the geometric average return for the S&P going back to 1926. Take a wild guess at what the 401(k)’s expected value becomes with that number?

And that number’s even somewhat inflated because it assumes 100% of the money is invested in the S&P for all 40 years.

And…

Neither of those numbers include inflation, which would eat up at least half of those accounts.

So why does Dave use such a high number for an assumed rate of return? I would have to say it’s to give people hope (a false sense of hope, but hope nonetheless). When people look at those numbers, they go, “WOW! I can do that? I had no idea!” I will admit, that those numbers are eye-popping.

But,…

Thoughts?

Two years ago we stopped investing in our 401k and we began paying thousands against the principal on our home. We only have $1,500.00 left to pay and the property is ours and we didn’t lose our a$$et$ to the stock market. We don’t have to worry about losing our home to the bank.

Our money isn’t tied up in unstable companies that could fail in a second with no warning. We are debt free and will now be able to live comfortable lives without worry. There’s something to be said about that don’t you think? If all of your money is placed in the stock market, which most likely it is. You most likely are worried that you’ll never get back what you just lost in the latest crisis. I don’t have that worry and in 11 years, I will have saved approximately $500,000.00 that I probably would have sank into the stock market and lost. Now that is a $500,000.00 gain in 11 years.

Can you beat that?

I don’t think so…

Oh, and did I mention that God was in all of this? That is right! God. If we all would just obey the Lord and keep his word, “owe no man nothing” then we wouldn’t be in the situation that were in today.

Wow…

Where do I start?

1. I NEVER said that going long on your mortgage and investing the difference was without risk. I do think that over the life of a 30-year mortgage, the risk is reduced.

2. Although you own your home you still have to pay property taxes. In some areas those taxes are small, but in other areas they can be quite high. Yes, not having a mortgage payment makes paying those taxes easier but you still have taxes to contend with.

3. Your money may not be tied up in “unstable companies” but it is tied up in your house and is quite illiquid. According to Jonathan Clements’ new book, The Little Book of Main Street Money, (review to follow soon) housing prices have increased an average of 4.7% over the last 30 years (through 2008). Inflation has averaged 3.8% per year during that same time period.

Chew on this…

EVEN WITH LAST YEAR’S -37% return for the S&P 500 Index, the index had a compound annual return over the last 30 years of 11%!

To put that in perspective, if you started 30 years ago with $100,000 invested in a house that appreciated 4.7% per year and $100,000 in the S&P 500 Index (minus 1% per year for fees), the house would be worth $396,644 at the end of 2008 and the S&P 500 Index account would be worth $1,744,940. And those numbers include some pretty dismal years for the S&P 500 Index. Even if you paid taxes at 28%, cutting your annual rate of return on the S&P 500 Index to 7.2% over the 30 years, you would have still had over $800,000 at the end of 2008—roughly TWICE what the house was worth.

4. I’m not sure where you’re getting the $500,000 in savings. Not including interest, you’re looking at having to save over $45,000 per year for the next 11 years to meet that goal. Surely I’m missing something here.

5. Lastly, you say:

“Oh, and did I mention that God was in all of this? That is right! God. If we all would just obey the Lord and keep his word, “owe no man nothing” then we wouldn’t be in the situation that were in today.”

If you truly believed that then why did you have a mortgage in the first place?

Seriously though, I think you are referring to Romans 13:8, which reads: “Owe no one anything except to love on another…” The notes in my Bible say that this is not a scripture against borrowing money, which the Bible does regulate and permit (Exodus 22:25; Leviticus 25:35-37; Deuteronomy 15:7-9; Nehemiah 5:7; Psalms 15:5, 37:21, 26; Ezekiel 22:12; Matthew 5:42; Luke 6:34). I think the virtue from the Bible that would have been more beneficial in preventing today’s circumstances would be not to love money (greed). Borrowing is both a tool and is necessary for an economy to function properly. It’s when the borrowing gets out of hand (usually due to greed) that we get into trouble.

Bottom line: you have to do what works for you. If the thought of owning your home is important to you, then by all means, own your home. But, that does not mean that it’s the best or most prudent decision for everyone else.

Thoughts?

Also see: Flawed Thinking (Part 2)

Years of bad decisions and stupid mistakes have created an economic nightmare in this country, but $700 billion in new debt is not the answer. As a tax-paying American citizen, I will not support any congressperson who votes to implement such a policy. Instead, I submit the following three steps:

Common Sense Plan.

I. INSURANCE

A. Insure the subprime bonds/mortgages with an underlying FHA-type insurance. Government-insured and backed loans would have an instant market all over the world, creating immediate and needed liquidity.

B. In order for a company to accept the government-backed insurance, they must do two things:

1. Rewrite any mortgage that is more than three months delinquent to a 6% fixed-rate mortgage.

a. Roll all back payments with no late fees or legal costs into the balance. This brings homeowners current and allows them a chance to keep their homes.

b. Cancel all prepayment penalties to encourage refinancing or the sale of the property to pay off the bad loan. In the event of foreclosure or short sale, the borrower will not be held liable for any deficit balance. FHA does this now, and that encourages mortgage companies to go the extra mile while working with the borrower—again limiting foreclosures and ruined lives.

2. Cancel ALL golden parachutes of EXISTING and FUTURE CEOs and executive team members as long as the company holds these government-insured bonds/mortgages. This keeps underperforming executives from being paid when they don’t do their jobs.

C. This backstop will cost less than $50 billion—a small fraction of the current proposal.

II. MARK TO MARKET

A. Remove mark to market accounting rules for two years on only subprime Tier III bonds/mortgages. This keeps companies from being forced to artificially mark down bonds/mortgages below the value of the underlying mortgages and real estate.

B. This move creates patience in the market and has an immediate stabilizing effect on failing and ailing banks—and it costs the taxpayer nothing.

III. CAPITAL GAINS TAX

A. Remove the capital gains tax completely. Investors will flood the real estate and stock market in search of tax-free profits, creating tremendous—and immediate—liquidity in the markets. Again, this costs the taxpayer nothing.

B. This move will be seen as a lightning rod politically because many will say it is helping the rich. The truth is the rich will benefit, but it will be their money that stimulates the economy. This will enable all Americans to have more stable jobs and retirement investments that go up instead of down. This is not a time for envy, and it’s not a time for politics. It’s time for all of us, as Americans, to
stand up, speak out, and fix this mess.

I think think this plan makes sense. Still, even under this plan we’re still going to see a lot of foreclosures. Those who purchased homes using interest-only mortgages and then only paid the interest-portion of the payment will never be able to afford a regular mortgage payment.

Dave’s also not quite clear on how we pay for the insurance program. Is this something paid for with tax dollars or is it something charged to the homeowner? I’m assuming it is taxpayer-funded. Regardless, I think this is a lot more tolerable than the massive $700 billion bailout that’s being discussed. What do you think?

If you like Dave’s plan, go check out his website to learn how you can help spread the word.

So did The Happy Rock save 12 – 18% during July? We don’t know because he never finished his analysis. Why? Here’s what he had to say about it:

The truth is that the no cash month [I think he meant "no plastic month"] was such a radical change in my habits that I was beat down by the end of the month. I didn’t have the energy to stay on top of things during the month and I was so discouraged at the end of the month that didn’t complete the analysis. I think part of me didn’t want to see that it saved money, because I wasn’t ready for the change. Another part of me wasn’t sure that I had been diligent enough in my record keeping to make the data meaningful.

I gotta say, I respect his honesty. Anyway, I have to hand it to The Happy Rock for giving it a try.

Personally, I think going all cash would be a pain in the butt. You can still cut your spending, you just have to be more diligent about doing it. For those who have SEVERE problems with overspending, then the cash-only option might be best as long as they stick to it.

*Incidentally, I asked one of Dave’s associates about Dave’s soundbite and this was his response:

“JLP, this is not really a quote that can be attributed. Dave never says “You know what they say…” or “Studies show that…” prior to making that statement. This is something that Dave has learned after decades of helping people with their personal finances. The point is that a lot of people can know the math of personal finances and still be broke if they can’t control the person in the mirror.

BTW, this is not an official statement on behalf of our company. It’s simply me answering a question that you asked.”

I wonder how he came up with it? I was thinking it was 70% behavior and 30% head knowledge. Or, maybe it’s 40% behavior and 60% head knowledge? I joke, I joke. But, I’m curious to know if any of you Dave Ramsey fans know how Dave came up with this little tidbit. If you know, please share.

Perhaps it’s related to the 80/20 principle (also known as the Pareto Principle). According to Wikipedia:

The Pareto Principle states that, for many events, 80% of the effects comes from 20% of the causes. Business management thinker Joseph M. Juran suggested the principle and named it after Italian economist Vilfredo Pareto, who observed that 80% of income in Italy went to 20% of the population. It is a common rule of thumb in business; e.g., “80% of your sales comes from 20% of your clients.”

I don’t think the Pareto Principal applies here because it doesn’t fit this scenario. Dave is saying that 100% of personal finance success is the result of 80% behavior + 20% head knowledge, while the Pereto Principal would say that 80% of personal finance success comes from 20% of something else (behavior or head knowledge).

Obviously you can have all the personal finance knowledge in the world but if you can’t control your behavior you’ll never get anywhere. So, you do have to have both ingredients. I just want to know how Dave Ramsey came up with his soundbite.

I don’t always agree with ol’ Dave but I have to respect the fact that he has been on the air for 15 years. That’s pretty amazing. Anyway, head over to PourOut for more information if you’re interested.

Okay, I just finished watching “Maxed Out,” the documentary about debt. Here’s my very broad summary:

Seriously. The “documentary” was full of snippets of nasty, mean Republican’s siding with credit card companies and nice, responsible Democrats standing up for Americans. There wasn’t much balance in this “documentary.” They did at least include some commentary from Dave Ramsey, who is a huge proponent of personal responsibility.

I found it both sad and disturbing at the amount of ignorance people have towards credit cards and debt in general. The 57-year old widow who was in the process of losing her house was pitiful. She got into debt easily enough and just kept taking on more and more debt because the loan companies kept giving it to her. In fact she even said something to the effect of, “I thought since they were giving it me, I could afford to pay it back.” I don’t think people realize just what they are getting themselves into when they sign a credit agreement. I really felt sorry for her (I even teared up during her last segment because I felt so bad for her), but the sad fact is that she got herself into her mess because she was playing with fire and didn’t realize it.

Another segment interviewed two moms whose kids got into debt while in college. Both of the kids ended up committing suicide because they found themselves so far in debt. Sadly, neither of the women took any responsibility whatsoever for the situation. Rather, it was all the credit card companies’ faults for issuing their kids credit in the first place. Granted, these kids had NO BUSINESS signing up for a credit card, but they did. Why didn’t these women talk to their kids about credit cards before they went off to college? They said they didn’t think about the fact that their kids could get credit cards while in college.

Folks, credit card companies are in business to make money. That’s it! It’s sad that companies will take advantage of people, but that’s the way it is. It’s up to us to decide how much they are going to make from us.

If I felt that this “documentary” was a little more balanced, I would recommend that it be watched by every high school class in America. It’s not balanced because it leaves personal responsibility out of the equation and is simply another tool to teach us that we are just victims in a massive credit card conspiracy.

He [Dave] doesn’t want you to pay off your home in 15 years; He wants you to pay it off in 12 years, or 10 or 7 or 4!!! Add those extra years of investing the $1700 house payment monthly and it’s probably a different picture. Digest the entire plan, not just bits and pieces, and you’ll end up ahead of the family in that right column. Good conversation you have going on here.

What would happen if you paid off a 15-year mortgage in 4 years? Would that change things? Let’s see…

In order to do this little calculation, I had to make some assumptions:

1. Taxes are ignored. There’s too many tax brackets and too many different scenarios. So, I decided to ignore taxes on both investments and the deductibility of interest.

2. I used the interest rates of 6.08% for the 15-year mortgage and 6.30% for the 30-year mortgage from yesterday’s post.

3. To pay off a $200,000 mortgage in 4 years, it would require an additional payment to be made of $3,000 per month, bringing the total monthly payment for the 15-year mortgage to $4,696 . The monthly payment for the 30-year mortgage would be $1,238.

4. I assumed that both families had an extra $3,000 per month. The family with the 30-year note is investing their $3,000 per month and getting an average return of 8% per year (or .67% per month).

5. After the 4 years is up, the family that paid off their mortgage early invests their entire payment of $4,696 per month and also gets an 8% annual rate of return.

Here’s what I came up with:

This all boils down to the fact that we have to make choices as to where we allocate our money. These choices involve picking one “return” for another. If you choose to pay an extra $3,000 per month on your house note so that you can be mortgage free in four years, then you also are making the choice NOT to invest the money elsewhere. This kind of thinking requires you to look at your personal finances like a business owner looks at their business.

81% of the pollsters think a 15-year mortgage is the best choice?

Being that it is on the Dave Ramsey website, these results don’t really surprise me. And, I suppose if you are looking at just the amount of interest paid, then yes, the 15-year mortgage wins. However, I think this is an awfully simplistic way to look at things because it totally leaves out the opporunity cost of going with the 15-year mortgage.

Remember the old saying that the A. L. Williams Insurance sales guys used to say, “Buy term and invest the difference?” Well, I have a saying when it comes to mortgages:

If the rates are right,…

According to my conservative numbers, you’ll come out about $90,000 ahead over 30 years. To compute that number, I used the following numbers:

6.08% APR for 15-year fixed mortgage (found on HSH Associates)
6.30% APR for 30-year fixed mortgage (found on HSH Associates)
8.00% Annual ROR on investments
3.00% Annual appreciation on the house

Then, I simply plugged the numbers into my Mortgage Comparison XL Calculator, and came up with the following:

Oh, and my results don’t even take into account the tax-deductibility of mortgage interest. So is a 15-year mortgage really a better deal?