Dave Ramsey is one of America’s most renowned money gurus. He has a rabid fan base of followers whose main goal in life is to get out of debt and stay out of debt. Being debt free is the first step to financial freedom, and being debt free affords you the freedom to live your life the way you want to live.
Dave Ramsey has designed a 7 step system as part of his Financial Peace University. These steps are designed to be a broad road map to help people get out of debt and march toward financial freedom. Over the next two weeks or so, we are going to explain in detail, the 7 Baby Steps. For now, here is an overview to the 7 Baby Steps, and a little background about them.
Step 0 – No More Debt!
Step 0 isn’t officially listed in Dave Ramsey’s 7 Baby Steps. But making a conscious commitment to change is essential before you will be able to accomplish any of these steps. It is nice to say you will do something, but another thing entirely to follow through with it. Once you make the commitment to live debt free, the following seven steps become easier to accomplish.
Step 1 – $1,000 to start an Emergency Fund.
Emergency funds are quite possibly one of the most important things you can do for yourself financially. You never know when you will need quick access to several hundred, or even a couple thousand dollars to deal with a car repair or a quick plane ride to visit family who live far away. An emergency fund will give you the funds to take care of these expenses as they arrive, and help you stay out of debt. The best place to stash your emergency fund savings is in an online savings account where you can earn a high interest rate and have easy access to your cash.
Step 2 – Pay off all debt using the Debt Snowball.
Dave Ramsey advocates using a debt snowball to pay off debts. Some people refer to this as “snowflaking,” which refers to taking small amounts of money (snowflakes) and combining them into a larger amount (snowball). Those small amounts of money can add up quickly, and a snowball is much more effective than a small snowflake. Ramsey advocates taking every small amount you can save and applying it toward your debt – instead of spending it on frivolous items. This concept has really taken off in the personal finance blogosphere, and has even spawned a Snowflake Revolution website and a network where members share how they have applied the snowflaking principle to debt reduction, investing, or any other applicable financial goal. Here are more tips on how to get out of debt.
Step 3 – 3 to 6 months of expenses in savings.
So you have an emergency fund, and you have paid off all your consumer debt… what’s left? Extended savings earning a high interest rate. An emergency fund is great if you need new tires, need to fly cross-country to attend a sick or dying relative, or need major car repairs. But what happens if you get laid off, or need a new roof, or you get injured on the job and are out of work for several months? Unemployment and disability insurance will be of some assistance, but they aren’t likely to cover all of your expenses. Your roof? Unless you can cover that with cash, you are liable to have to go into debt, erasing everything you worked so hard to accomplish in Baby Step 2.
Having 3-6 months living expenses at your disposal will make it much easier for you to make it through an extended period where your income does not match your expenses. Having this money gives you freedom. Freedom from worrying about one small slip forcing you back into crushing debt and the associated pressures that come with it. The best course of action is to save this money in a high yield savings account such as Discover Bank where you can earn a solid return on your money.
Step 4 – Invest 15% of household income into Roth IRAs and pre-tax retirement.
One of the best financial feelings I can remember was when I first saw some real growth in my savings. When I was younger, $10 represented over 2 hours work for me. Then one month, after I had been saving for several months, I looked at my bank statement. I had earned over $10 in interest. My money was working for me! Nowadays, $10 doesn’t seem as much to me, but the concept remains the same. You need your money to work for you if you are ever going to be financially free. Saving for your retirement in tax advantaged accounts is the best way to make progress for long term savings.
Dave Ramsey recommends investing 15% of your household income (or more if you can afford it) into Roth IRAs and pre-tax retirement accounts. I agree with Dave, Roth IRAs are better than Traditional IRAs. If you are considering a pre-tax account, your options are generally a Traditional IRA or a 401(k), or equivalent. Whether you choose a 401(k) or IRA will depend on your situation.
Step 5 – College funding for children.
By Step 5, you should have an emergency fund, be out of debt (except a mortgage), have 3-6 months living expense to cover major life events, and already be contributing 15% or more toward your retirement savings. If you have children, your next major expense will likely be college. Should you pay for your children’s college expenses? The answer varies from parent to parent, but you should be aware of this – when colleges process student loan and grant applications, they often take into account parental income levels.
Whether or not you assist your children through college is a decision you will have to make on your own. But there is one thing I like – Dave Ramsey recognizes it is very important to place your retirement savings ahead of college savings for your children. You only get one shot at retirement, and you can’t borrow your way through it. College on the other hand… You can receive loans and grants, which can be borrowed and repaid. If you decide to help fund your child’s education, consider opening a tax advantaged college savings account such as a 529 College Savings Plan or a Coverdell Educational Savings Account (ESA).
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Step 6 – Pay off home early.
Many people debate whether or not it is better to repay mortgage debt early, and there are strong arguments for both sides. Mortgage debt is generally inexpensive debt and mortgage interest is a tax deduction for most people. Investing money you could use to prepay your mortgage could potentially earn you much more money in the long run.
On the other hand, mortgage debt is still debt. If you already have completed steps 1-5 and have additional funds every month, paying off your mortgage early will free up more money every month and allow you other freedoms that you would not have with a mortgage.
The freedom of no mortgage debt: A friend of mine is in his mid-thirties and paid his mortgage off completely. This allowed his wife to quit work and stay at home to raise their three children. They have no other debts, and he recently took a lower paying job because it brought him more satisfaction at the end of the day. He wasn’t trapped by an enormous mortgage, or saddled with other debt. Being debt free allowed his family to make these decisions to live the life they want to live, not live the life they are force to live to just to repay debt.
Step 7 – Build wealth and give! (Invest in mutual funds and real estate).
This is Dave Ramsey’s final baby step. In my opinion, this step is open to interpretation based on personal beliefs, needs, and situations. I understand each element, but in my opinion, it seems like a couple different ideas were thrown together into one step. Let’s break them apart and examine them one by one.
Building wealth: With no consumer debt, a large fall-back fund, 15% or more of you income going into retirement accounts, your children’s college paid for, and your mortgage eliminated, you may have extra funds to play with every month. If so, wealth building is the next logical step. Of course, by investing for retirement, you have been building wealth all along. But, I suspect Dave Ramsey is referring to building non-retirement wealth.
Ramsey mentions investing in mutual funds and real estate. I would prefer to invest in index funds over mutual funds because the fees are generally much lower, but the idea is the same. As for real estate, the reason I believe he mentions that is to grow an alternative income stream; something that will bring in income outside of your normal job. I commend this type of thinking, but real estate is not for everyone. However, I believe alternative income is important for everyone to strive to achieve.
Invest to build wealth, but make the types of investments that suit your needs.
Giving: Dave Ramsey is big on giving, and advocates tithing 10% throughout all the baby steps. Giving, by his definition, is anything about 10%. Giving is a very personal thing, and not something you should rely on someone else to tell you how or when to do. You should do what you believe to be the right thing to do.
I should also note that if you are tight on money, there are other ways to give. Giving of your time, energies, talents, or other forms of giving can often make a greater difference than just throwing some money in a pot.
Dave Ramsey’s 7 Baby Steps: Wrap-up
Overall, I think Dave Ramsey’s plan is a solid plan to get out of debt, build wealth and reach financial independence, and ultimately, financial freedom. There are a few caveats though – this plan should be viewed as a rough guide, and not an absolute road map. Everyone has different personal and financial situations and goals. But if you are able to use this guide as a rough outline, your chances of meeting your financial goals are very good.
Stay tuned this week for more in-depth articles covering these topics.
- Dave Ramsey’s Baby Steps Overview – Cash Money Life
- Step 0: No More Debt! – Single Guy Money.
- Step 1: $1,000 to start an Emergency Fund – Gather Little by Little.
- Step 2: Pay off all debt using the Debt Snowball – I’ve Paid For This Twice Already.
- Step 3: 3 to 6 months of expenses in savings – Being Frugal.
- Step 4: Invest 15% of household income into Roth IRAs and pre-tax retirement – The Dough Roller.
- Step 5: College funding for children – My Two Dollars.
- Step 6: Pay off home early – Moolanomy.
- Step 7: Build wealth and give!
This article is a general overview of the 7 basic principles of Dave Ramsey’s Baby Steps and is not intended to replace his course, nor is this sponsored or endorsed by Dave Ramsey or the Lampo Group.