As much good as he does, Dave Ramsey drives me nuts with his views on debt. Dave Ramsey, as he readily admits, did some really stupid things with debt. Leveraged to the hilt on bad real estate deals, he went bust in a way most of us could never imagine. Even as a real estate investor, my leverage and borrowing comes no where near the toxic level Dave Ramsey went to. Why? Because Dave Ramsey’s personality is one of extremes. Much like an alcoholic, he could not control his use of debt. He got one taste of that leverage, and he was borrowing before noon ever day.
Dave Ramsey is a Recovering Debtaholic
Now, he is a recovering debtaholic. Like a recovering alcoholic, he should never borrow again. Why? He just can’t handle it. Put Dave Ramsey and debt together, and something really ugly develops.
Ok, fine. But why should that apply to all of us? It’s as if a recovering alcoholic were telling the rest of the world never to have a glass of wine. In other words, what works and doesn’t work for Dave Ramsey may not apply to everybody else. Of course, there are those who, like Dave, can’t control debt and should avoid it just like he does. But debt — if used wisely — can greatly improve one’s finances, can increase one’s financial freedom, and can greatly improve your balance sheet.
Own versus Lease–there’s really no difference
Being debt-free does not automatically mean you’ve achieved financial freedom. For example, in the world of accounting, there are some intricate rules relating to how a company should account for a lease. Part of the reason for these rules is to prevent a company from appearing to improve their balance sheet when, in reality, they haven’t.
Let me explain. Suppose a company owns a building and has a $1 million mortgage on the property. The mortgage of course is reported as a liability on the company’s balance sheet. So, what if it wanted to get that mortgage off its balance sheet, but still keep the building? Well, it could sell the property and then lease it back from the buyer under a long-term lease. Is the company any better off? No, it’s just changed the legal form of its ownership of the building. It’s still obligated to pay for the building each month, but now the payment is called “rent” rather than a mortgage payment.
We can do the same thing renting a house or leasing a car. You may not have debt, but you do have financial obligations that require monthly payments. And you’ll never own outright the thing you’re paying for each month.
The Real Deal on Debt
So, here’s the deal: being debt-free is not the holy grail of financial freedom. My wife and I could be debt-free quite easily. We could sell our house, pay off all our debt, and have some money left over. I guess we’d then rent a house or apartment, and I would continue to go to work everyday. Would we be more financial free? Nope. I suppose we could move to a less expensive area and perhaps even pay cash for a home. Would we be any more content in life? Nope. In fact, all we’d end up doing is uprooting our family and moving away from a place we love.
Now, the point here is not to run out and start borrowing. But I would suggest considering the following guidelines when it comes to borrowing money:
- Avoid borrowing to buy something that’s not a long-term hard asset: That means don’t borrow to go on vacation, or go out to fancy restaurants, or to line your closet with expensive clothes. One of the reasons we are financial free, even though we have debt, is that we have tangible assets behind the debt (our house) that we could sell if we wanted to and be debt-free. Once you take a vacation, you can’t sell it to pay off the debt.
- Keep total debt payments below 30% of your gross income: I know that for many this will be very difficult, particularly if you live in an expensive area. But I’ve found that if monthly debt payments exceed 30% of your gross income, life gets very uncomfortable. And I should add that as you get older, this percentage should be going down. It should go down because your income should be going up, and it should also go down as you pay off debt. If you’ve read my articles about how Lending Club sets interest rates, you know that you must have a debt-to-income ratio of 30% or less to borrow from Lending Club. That ratio, however, doesn’t include your mortgage or rent payments. Here, I think it should. The goal is to keep all debt payments, including housing, below 30%.
- Borrow wisely: We should all know by now the dangers of variable rate mortgages. Mortgages should be on 15 or 30 year fixed rate loans. Take advantage of 0% credit card offers when it makes sense to do so. You can check out some 0% balance transfer credit card offers.
- Don’t spend today what you’ll earn tomorrow: This really ties into the first guideline above. But the point is to control your spending, and don’t let easy access to a loan take your spending out of control. There are plenty of free online budgeting tools you can use that will help you track and control your spending. Use whatever works best for you.
Dave Ramsey is entertaining, and I agree with a lot of what he preaches. And if you choose to avoid debt like he does, I certainly won’t tell you that’s a bad decision. But I also believe that responsible borrowing can improve your finances with modest risk. So what do you think–is Dave Ramsey’s approach to debt the right approach for everybody?