“Debt is dumb. Cash is king.”
— Dave Ramsey
“I like the way I’ve built wealth better than the way you haven’t.”
— Dave Ramsey
A READER DEBT QUESTION
After the last post, one of my readers asked, “What is your thought on the Dave Ramsey approach to no credit score…?”
Answer: Ramsey hates debt. And he cheers people who become free of all debt. So, a credit score does not matter. He feels it is ok to let your score dwindle or even become zero.
But at MMH, I believe that there are situations when debt is advisable and cash is not. And, I don’t completely buy the credit score argument either.
This post will discuss exceptions to Ramsey’s “no debt” point of view.
WHO IS DAVE RAMSEY?
Ramsey is a famous personal finance expert. Through his nationally syndicated radio show, books, and television appearances, he has created a business empire and helped thousands of people, particularly those with debt issues.
His primary message is that debt prevents financial independence. Therefore, he believes debt elimination is a key to achieving success and wealth.
RAMSEY’S ONE EXCEPTION TO THE NO DEBT RULE
Ramsey does believe in a home mortgage. However, its use comes with two restrictions. First, the loan can be for only a 15-year term. And you can only have 25% of your take-home pay for mortgage costs.
He also argues that you can apply for a reasonable home loan without having a credit score.
A RAMSEY RULE BREAKER: WARREN BUFFETT
You have to wonder about advice when a well-regarded person doesn’t follow it.
Buffett is arguably the greatest investor in history and is worth about $100 billion at this writing—even after giving about half of it to charity. So, why did Warren Buffett get a mortgage and incur debt on his second home? And why did he admit that he should not have purchased his primary residence in cash?
And if that were not enough, why did Buffett obtain a 30-year loan instead of a 15-year term?
What does Warren know that Dave does not?
WHY BUFFETT GOT A 30-YEAR MORTGAGE
Buffett took Ramsey’s preferred advice on his first home. He paid for it in cash in the 1950s.
However, Buffett later realized that his decision cost him. He could have invested the money instead of tying it up in a house.
So, when Buffett bought a second property, he incurred debt and used a 30-year mortgage.
The point: there are exceptions to anything.
WHEN DEBT IS GOOD, AND WHEN NO DEBT COSTS YOU MONEY
This post is NOT an endorsement of debt. Instead, I will describe when you should consider paying in cash and when you should pay on credit.
If you borrow, ONLY borrow when it is advantageous to you. And don’t take outsized risks. Ending up with zero is unacceptable.
So before making significant debt decisions, consult with a financial fiduciary first. Sometimes debt is complicated, and a fiduciary can educate you about the risks and rewards.
What follows are the exceptions to no-debt rules.
EXCEPTION 1: IF RAMSEY’S RULES ABOUT HOUSING AND MORTGAGE DEBT PREVENT YOU FROM BECOMING A HOMEOWNER, PLEASE RECONSIDER.
Taking on mortgage debt is a risk. But remaining a renter all your life is a risk too. Most millionaires don’t rent. The overwhelming majority of millionaires own their homes or real estate, with a few notable exceptions.
Moreover, homeowner equity is usually a key factor in a successful retirement.
So, be flexible in making a homebuying decision. Most people lean strongly toward purchase.
People should be careful about following rules that may prevent them from ever being homeowners. In the real-world example below, you can understand how restrictive Ramsey’s limitations are.
Example: The average home price exceeds $500,000 in the U.S. To borrow $400,000 on a 15-year loan requires paying around $3,100 per month at July 4, 2022, published interest rates. See below.
Moreover, the guidelines are restrictive, and you are supposed to use only 25% of your take-home pay for mortgage payments.
Take-home pay varies from person to person. Given Social Security deductions, Federal and State taxes, and other withholding, a reasonable guess is that 25% of take-home pay means you must gross roughly five times your monthly mortgage to comply with Ramsey’s guidelines.
The results of this typical situation show how hard it is to make the restrictions work. A family must earn $180,000-190,000 per year to purchase an average-cost house with a 20 percent down payment. The average U.S. household income is $87,864. The median income is far less.
EXCEPTION 2: USE OF A 30-YEAR FIXED MORTGAGE DEBT MAY ALSO PROTECT YOU IN AN ECONOMIC DOWNTURN, AS IT IS MORE FLEXIBLE
Ramsey recommends a 15-year loan because you pay it off faster. It also carries a lower interest rate. However, the starting payments are higher–often much higher.
Taking on a higher payment can be risky when there is economic uncertainty, even if you only spend 25 percent of your take-home pay on mortgage costs.
Example: As of July 4, 2022, rates, borrowing $400,000 at 5.6% for 30 years costs $2,296 per month. Borrowing $400,000 for 15 years at 4.9% costs you $3,142 per month—almost $850 per month more.
When doing your financial planning, you must consider your cash flow in an emergency. For example, a recession or medical crisis can result in unemployment and reduce the amount of money you make. That, in turn, can make paying that $850 a month a lot tougher. And don’t forget—refinancing that 15-year mortgage to reduce its cost while you are unemployed is difficult. It takes income to pay a refinanced loan, and most lenders don’t want to lend to the unemployed.
Finally, no one is stopping you if you want to add that extra $850+ per month to your 30-year loan. It will allow you to repay that mortgage in around 15-16 years.
But a 30-year term allows you to decide whether to pay the extra $850 or not. If your mortgage has a low-interest rate and there is high inflation at some point, you may be better off investing the $850 monthly savings elsewhere, not paying down your loan.
EXCEPTION 3: BORROW ON A CREDIT CARD WHEN THE CARD GIVES YOU A BETTER DISCOUNT THAN PAYING IN CASH.
Many cards give you a 2% cashback. That is like getting a discount on something you would buy anyway.
But always pay off your credit card entirely each month. To do otherwise can be extremely expensive.
Example: we travel. We could pay for trips in cash. But, on a $10,000 trip, we get two percent ($200 back) if we use our credit card. The travel group we often use gives us a discount for paying cash too, but not as much.
EXCEPTION 4: BORROW WHEN YOUR PURCHASE IS FAR MORE EXPENSIVE IN THE FUTURE.
The key here is to see whether the cost of what you borrow is less than paying a future inflated price.
Example: your dishwasher is wearing out. A price increase is coming next month for a new one. You can borrow to pay $1,000 now or pay $1,150 next month for the same model.
This situation requires evaluating tradeoffs. Credit card interest rates are brutal. But so is paying $150 more for the same dishwasher model a month later. Sometimes it is better to borrow, especially when you can quickly repay the loan. The cost of the interest may be less than the price increase.
EXCEPTION 5: BORROW FROM A CREDIT CARD IF THERE ARE CARD BENEFITS YOU WOULD OTHERWISE PAY FOR
CAVEAT (AGAIN): SAVE THE FULL COST OF YOUR CHARGE UP FRONT, AND THEN PAY THE BACK THE CARD COMPLETELY AT THE END OF THE MONTH
It is critical to know what your card covers and does not cover. There can be significant savings on items important to you.
Example: we need trip insurance when traveling overseas. That can often total as much as $1,500 for the two of us, as much as nearly twenty percent of the total travel cost. We saved money by choosing a card with provisions that protected us instead. For an example of that, see here.
Another example: some cards have provisions that cover you when your phone is damaged or needs replacement. Depending on your situation, that can save you money. But, again, you must evaluate the tradeoffs.
EXCEPTION 6: BORROW WHEN THE BENEFIT STRONGLY OUTWEIGHS THE DEBT COST
Example: student loans— College graduates make more than a million dollars more in income over a lifetime versus those who do not attend. See here.
BUT your success depends upon two things: 1) that your major is lucrative (see here for a list), and 2) you keep the cost of tuition and other college costs to a minimum.
If you graduate with a low-paying major and incur expensive private school tuition, paying back student loans is problematic. For instance, if you only make $35,000 per year upon graduation, paying back a student loan of $450,000 will leave you broke.
EXCEPTION 7: BORROW WHEN YOUR FUTURE EARNINGS WILL DWARF YOUR DEBT
This situation only happens to a lucky few, but it is something to keep in mind.
Example: you have graduated from medical school, nearly finished your residency, and want to buy a home. Some lenders will make a loan to you when you might not otherwise qualify. Approval occurs because lenders base their decision on a high future income.
EXCEPTION 8: BORROW WHEN YOU CAN BENEFIT FROM ARBITRAGE
Arbitrage occurs when you can take advantage of a difference in prices or interest rates.
Example: you want to buy a car, and the factory is offering special financing at 1.8% over five years. However, you can get three and a half percent on an investment during the same five-year period. Therefore, you might consider taking advantage of the difference in rates and borrowing rather than paying for a car outright.
Of course, this situation is hypothetical. There are bigger issues to figure out first when purchasing a vehicle. For instance, can you afford the car, or would a used car be better given your budget? Has the car price been jacked up to compensate for cheap financing? Are the operating costs for the vehicle reasonable for your budget–and so on.
EXCEPTION 9: BORROW FOR RENTAL REAL ESTATE WHEN THE TRANSACTION IS FAVORABLE (THE READER’S QUESTION)
As the reader pointed out in his full question text, purchasing a rental property is a valuable tool for building wealth. However, pulling off direct ownership of an entire rental property is tough if you are in a cash-only mode. Moreover, trying to borrow without a credit history is complicated.
Instead, people with a cash-only bias can buy fractional shares of real estate through Real Estate Investment Trusts and other entities.
A FINAL WORD: IT IS IMPORTANT TO AVOID FINANCIAL RISKS—BUT DEBT IS JUST ONE TYPE
Becoming financially independent is about avoiding risk and making solid money decisions. So outsized risks should be avoided. And debt and overspending are major causes of bankruptcy.
However, medical bills, divorce, and job loss are also significant causes. So, you could argue that taking steps to stay healthy, maintain a good relationship with your spouse and keep up on your job skills should get equal time.
Look at your situation thoroughly. And know when you need to make exceptions.
Disclaimer: consult with a financial fiduciary before taking any steps outlined here. Not all advice may be suitable for your circumstances or investment style.
Image: Ian Taylor
License: Unsplash