I’ve written a bit about Dave Ramsey before, most notably regarding his budgeting methods.
Overall, I like his podcast and books. His advice is simple, straight-forward and motivating.
Dave has a number of rules of thumb when it comes to managing your finances. While I find financial rules of thumb helpful in some situations, I see times where they might lead someone to make a bad decision.
Having read his books and listened to his podcast, there’s 10 Dave Ramsey financial rules of thumb I’ve come across. Here are those 10 rules of thumb, along with analysis of the recommendation.
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Dave Ramsey’s Financial Rules of Thumb
# 1 – How much house can I afford?
Financial Rule of Thumb: Limit your mortgage payment (including insurance, HOA fees and taxes) to 25% or less of your monthly take-home pay on a 15-year fixed-rate loan.
Analysis: Sound advice here. If you can afford to save 20% down and take out a 15-year mortgage, you’re doing a lot of things right.
# 2 – How much should I spend on a car?
Financial Rule of Thumb: The total value of all of your vehicles should not be more than half of your annual income.
Analysis: This seems high. The issue for me is that it doesn’t take other debt into consideration. For example, a couple earning $100,000 a year combined, yet still has student loans shouldn’t have $50,000 worth of vehicles.
There are also many quality, fuel-efficient used cars in the $8,000 to $12,000 range one can buy.
My rule here would be until you have your non-mortgage debt paid off and are saving 25%+ of your income, stick with a vehicle in the $8K to $12K range.
# 3 – How should I invest?
Financial Rule of Thumb: Dave recommends you invest in 25% of your total portfolio in a growth mutual fund, 25% in aggressive growth mutual fund, 25% in an international fund and 25% in growth and income.
Analysis: Dave Ramsey is often criticized for his investment advice. In my opinion, it’s for good reason.
Not only is this portfolio very complicated for even intermediate investors, it’s far from optimized.
Even Time Magazine has said,
“…if you’ve gotten through the baby steps of conquering debt and starting to save, you’d be wise to graduate to better advice on investing.”
I recommend the same.
Read John Bogle’s The Little Book of Common Sense Investing in a night and place yourself in the top 10% of investors.
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# 4 – When should you start investing?
Financial Rule of Thumb: Once you’d paid off your non-mortgage debt and have a 3-6 month emergency fund (baby step # 3)
Analysis: For most this is solid advice, which is after all the purpose of a rule of thumb. Where I would break this rule is when someone has low-interest rate debt and a company 401(k) match. For example, say you have student loans at 5% and a company 401(k) match at 50% of the first 6%. In this scenario, I’d recommend contributing up to your match, then attacking the student loans with anything left.
# 5 – How much should I save for retirement?
Financial Rule of Thumb: Save 15% of your income.
Analysis: This is a good rule of thumb, as 15% is the amount one would need to save over the course of their life to have an equivalent lifestyle during retirement.
But then again, if you’re reading a personal finance blog, you’re probably not typical.
While 15% is good to aim for, if you want to retire early or you’re starting late, you’re going to need to bump this. I’d prefer someone to use Personal Capital’s Retirement Calculator and play around with different saving rates. Many will be surprised at how much quicker they’ll reach financial independence by bumping this up just a few percentage points. Or, how much they must save if they started late.
# 6 – How much life insurance should I buy?
Financial Rule of Thumb: 10-12 times your annual income for life insurance.
Analysis: Rules of thumb in life insurance are tricky. For example, say you have a family of three, where both the Husband and Wife make $60,000 a year. In this case, each spouse would buy $600,000 to $720,000 of life insurance. Next, say you have a family of six in a one-income household, making $60,000 a year. This family would again purchase $600,000 to $720,000 in insurance–yet their needs are much different.
I’d much prefer someone to spend 30 minutes completing a half-dozen online calculators (this is one of my favorite and Dave has one on his site). This will allow you to get a feel for what needs to be planned for.
# 7 – How big of an emergency fund?
Financial Rule of Thumb: 3-6 Months of expenses
Analysis: This is one rule I personally like to break. I only carry on average about two months. I like to invest anything over this amount as fast as possible.
The opportunity cost of having an additional 4-months of expenses sitting in cash is too great over my lifetime.
My back of a napkin calculation for this is as follows:
Say I have access to credit card debt at a 16% interest rate. If I were to spend 50% of my time in “emergency mode,” I’d be paying on average 8% to carry a lower emergency fund.
As 8% is around what the stock market returns, this then is my break even point. As long as I’m spending less than 50% of the time in emergency mode, I come out ahead. As it turns out, I spend a lot less time than 50% in emergency mode. So, this works for me.
But there are others I wouldn’t recommend this strategy for. For example, someone who takes a lot of risk in their career. There’s something about sleeping well, knowing you have a 6-months of expenses saved up.
# 8 – Pay off the debt with the highest interest rate or smallest balance?
Financial Rule of Thumb: Pay off the debt with the smallest balance first
Analysis: This is another rule I’d personally break. Instead, I’d pay off the debt with the highest interest rate first.
Yet, I can see where this makes sense in some situations.
For those living paycheck to paycheck, I can see where paying the lowest debt makes sense.
For those living below their means, I’d lean towards paying off the highest interest rate first.
# 9 – How much do I need to retire?
Financial Rule of Thumb: Be able to live off of 8% your nest egg
Analysis: This one goes hand and hand with the 12% rule, which in my opinion is dangerous.
Every major study, most popular is the Trinity Study, has cited withdrawal rates between 4% to 5% maximum.
In other words, if you have a million dollar portfolio, you can withdraw $40,000 to $50,000 a year without running out of money. This is of course if you have an optimized portfolio.
Based on historic results, an 8% withdrawal rate for 30 years, would have worked in only 37% of situations.
# 10 – How much should I spend on an engagement ring?
Financial Rule of Thumb: One month’s pay
Analysis: This advice here works as a rule of thumb–meaning it’s widely applicable.
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