It pays to use good judgment when it comes to over-the-top financial advice.
- No one is successful 100% of the time.
- Relying on more than one source for financial advice may be the best bet.
Whether you love him, hate him, or haven’t heard his name before, Dave Ramsey has followers, followers who cling to his every word. Some of what Ramsey says makes a lot of sense. After all, debt stifles financial dreams, and living beyond your means usually leads to problems. However, there are certain Ramseyisms that we cannot follow.
READ MORE: How to repay a debt
Pay off your mortgage sooner
The idea of living without a mortgage is pure bliss, and that alone can be worth anything. But if your mortgage interest rate is significantly lower than the amount you could earn on your investments, why the hell would you choose to pay off your house instead of investing?
To get an idea of how much spread Ramsey might have with this nugget, we looked at the average 30-year fixed mortgage rate in January of each year from 2000 to 2020. When we averaged those years, we got 4.67%. We wanted to include the years during and around the Great Recession because the interest rates there were pretty low there for a while.
We also looked at how the S&P 500 performed between 2000 and 2020. After adjusting for inflation, the S&P 500 averaged 6.76% per year.
Suppose someone bought a $ 300,000 house in 2000, took out a 30-year mortgage, and had an extra $ 300 each month to pay off their mortgage or invest in the S&P 500. How these two monthly investments compare -they ?
Result after 20 years
Pay home early
Home planned to be reimbursed 8 years, 7 months earlier, for a total savings of $ 83,320
Invest in the market
Adjusted for inflation, gains of $ 143,773
The beauty of making regular house payments and investing the extra $ 300? Even though the value of the home purchased in 2000 has skyrocketed over 20 years, the homeowner still benefits from the additional equity whether the home is paid in full or not.
We’re not saying no one should pay off a mortgage sooner. The point is, it’s not the right choice for everyone. Investing has historically been a better bet for anyone looking to oversize their retirement account.
READ MORE: How to open a brokerage account: a step-by-step guide
And speaking of returns
Ramsey likes to tell people that they will earn 12% on the stock market. To this we ask: “When? Which ? And how ? There are so many things wrong with Ramsey’s promise to his followers that we’ll have to break them down.
Average annual returns are only a small part of the picture
Say someone inherits $ 1,000 and decides to open a brokerage account and invest the money. The first year has been excellent and the investment has paid off 100%. The following year was tough and the investment lost 50%. A little simple calculation shows that the average annual return over those two years was 25%.
It wasn’t 25%, and here’s why: In the first year, the investment increased 100%, to $ 2,000. The following year, he lost 50% to bring it down to $ 1,000. In other words, the investor was back where he started two years earlier with $ 1,000. In any book, that’s a total annual return of 0%.
Ramsey was using old numbers and (too) simple math
According to Ramsey’s website, his 12% income promise is based on the average annual return of the S&P 500 from 1928 to 2020 (that gross percentage is actually around 11.64%). While that sounds pretty impressive, this average doesn’t take into account volatility, high fees charged by some brokers, and inflation.
Remember our illustration comparing prepaying a house to investing in the S&P 500? There is a reason we used 6.76% instead of 11.64%. That’s because 6.76% reflects actual growth after all other factors, fees, and disruptions are factored in. Being realistic about what you can expect to earn can keep you from making big mistakes, like being overly optimistic or underfunding your investments.
No human being is completely right or completely wrong, and on occasion we grab advice from Ramsey that is just about the money. That said, putting all of your trust in one person – especially when that person is the best dog in their business and may or may not have someone to tell them when they’re off base – is a dangerous practice.
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