There's really no need to get bent out of shape by Dave Ramsey's debt reduction advice. Image source: o5com via Flickr.
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Dave Ramsey and I have a brief -- but very colorful -- history with each another. Back in 2013, I penned an article on why I considered some of his retirement advice to be dangerous. Specifically, I called him out for telling investors to expect a 12% return on their investments using a metric (average annual return) he knows isn't suited to make such predictions. (It should instead be the compounded annual growth rate, or CAGR, that is used, and is just over 9% historically, since 1871.)
He had me on his radio show to discuss the article. It wasn't pretty. In fact, a lot of ink was spilled afterwards based on the interaction.
I followed up with an article showing how following Ramsey's retirement advice would give you a 50% chance of running out of money by age 90. Finance expert Felix Salmon reached much the same conclusion in a piece for Money Magazine.
Suffice it to say, then, that I don't shed too many tears when I read others' thoughtful disagreements with Ramsey's investing advice. However, in the process of reviewing such pieces, I've found the same anti-Ramsey argument come up over and over again. But this argument is based on Ramsey's debt reduction plan -- and I believe that those who disagree with Ramsey on that particular issue completely miss the point of behavioral finance.
The Motley Fool's mission is to help the world to invest -- better. Since you can't invest without reducing your debt, I think it's worth pointing out why this anti-Ramsey argument is misguided.
Theory vs. practiceRamsey's bread and butter is helping people get out of debt. It's that topic that he has personal experience with: He declared bankruptcy at a young age and used the experience to fuel his current career. I think it'd be fair to estimate that over 90% of the time, Ramsey is focused on the debt reduction (as opposed to the investing/retirement) part of the equation.
To help ordinary folks get their financial house in order, Ramsey has 7 Baby Steps that he recommends taking. It is the second Baby Step -- "Pay Off Debt" -- that garners such myopic criticism. Here's what his official website says about the step.
Image source: www.daveramsey.com.
The focal point for detractors is the part about paying off the smallest debt first, instead of the debt with the highest interest rate.
In theory, the detractors are right. By not paying off the largest debts first, a person is likely to pay more in lifetime interest than if she focused on high-interest loans. Here's an example of one such article from Nerd Wallet that takes this stance.
Theory, however, only matters in the classroom; it is often a poor proxy for real-life human behavior. The key is that theory assumes an individual will continue to pay down debt regardless of the approach.
But that isn't how the real world works at all. A family that is struggling to make ends meet might quickly give up on the process of paying down debt if they don't experience some sort of emotional boost to keep them going.
That's where Ramsey's plan comes in. In much the same way that checking things off your to-do list makes you feel productive, closing out accounts one by one gives you the satisfaction and feeling of progress necessary to motivate you to keep paying down your debt.
Ramsey himself acknowledges this difference, stating on his webpage:
With that, I can't argue one bit. Felix Salmon, who wrote the piece criticizing Ramsey's investing advice, also has glowing things to say about this debt advice:
Real-world results?A 2011 study by researchers in America and Israel found that Ramsey's approach was one of the most commonly used in debt reduction, as it allows people to experience the positive emotions associated with closing down a debt account.
However, they also found that if subjects were set up in a debt management game, those results could change. Specifically, the researchers "found that eliminating participants' ability to completely pay off small debts actually improved their overall financial situation."
That's all fine and good, but the fact of the matter is that Ramsey -- neither through his classes nor through his radio show -- cannot manipulate listeners' accounts the same way researchers can within a laboratory setting.
That, plus the fact that Ramsey genuinely explains why he advocates the plan he does, should be enough to convince readers that, though there isn't one perfect way to reduce debt in the real world, Ramsey's method has worked for many and is at least worth considering.
The article Criticizing Financial Guru Dave Ramsey for This Advice Misses the Point Entirely originally appeared on Fool.com.
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