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A Review of Dave Ramsey’s Baby Steps To Financial Freedom

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Posted by on March 19, 2011 0 Comments Category : Blog &Questions

Dave Ramsey’s Baby Steps is a financial plan designed to help you get your finances in order, get out of debt, and achieve financial freedom. Dave Ramsey has taught these Baby Steps to millions via radio, The Total Money Makeover, Financial Peace University, and on DaveRamsey.com. In this article, I’d like to walk you through and review each step.

Baby steps
Photo by billerr via Flickr

Dave Ramsey’s Baby Steps

The followings are the seven steps in Dave Ramsey’s financial plan.

  1. $1,000 to start an Emergency Fund
  2. Pay off all debt using the Debt Snowball
  3. Three to six months of expenses in savings
  4. Invest 15 percent of household income into Roth IRAs and pre-tax retirement
  5. College funding for children
  6. Pay off home early
  7. Build wealth and give!

The first thing I’d like you to note that Dave’s plan is not the only financial plan. However, it is as a good plan and it works. So it’s a good place to start if you’re looking to get out of debt and get your finances in order. You should also note that Dave’s plan focuses on the psychology more than the mathematics, and this is one reason why it works better for so many people.

Baby Step 0: The Unlisted Step

I have seen different variations of Baby Step 0, but I think everyone agrees that the most important thing that one must do before embarking on the journey that encompasses the Baby Steps is to make a commitment to change. Some people got into financial trouble due to bad luck, but most got there because they made bad financial decisions and decide to live with bad money habits. For these folks, the very first step is to change these bad habits and make a commitment to turn things around.

Here are a few articles that discuss Baby Step 0

Baby Step 1: $1,000 to start an Emergency Fund

The first official step of Dave Ramsey’s Baby Steps is to start an emergency fund. This even takes precedence over paying down debt. The key reason to start an emergency fund is to prevent you from slipping back into the mindset of borrowing to deal with financial problems.

How to fund your emergency fund?

This is where making changes to your spending habits will come in handy.  Review your expenses and find ways to save money. And if saving money alone is not good enough, you should figure out various ways to earn more money.

Where to keep your emergency fund?

Despite the low interest rate, the best place to keep an emergency fund is in a good online savings account.

Counterpoints

Although I believe having an emergency fund is important, I prefer paying down debt to starting an emergency fund. I am not alone on this — for example, Suze Orman supports this method in her book: Suze Orman – For the Young, Fabulous & Broke. In any case, either method should work fine for you.

Here are a few articles that discuss Baby Step 1

Baby Step 2: Pay off all debt using the Debt Snowball

debt-snowballThe second step is to pay off your debts using the Debt Snowball method — except your mortgage. The Debt Snowball method is a technique that helps you focus on paying off your smallest debt first, so that you have a greater ability to pay off the next smallest debt (click on the image on the right to see a full explanation of this method).

Baby Step 1.5: Negotiate Interest Rates On Your Debts

Before I talk about where I deviate from Dave Ramsey’s plan, I should note that there’s a worthwhile step to perform before starting your debt snowball. This step is all about lowering the interest rates on your current debts. Here are a few things you can do:

Counterpoints

This is another point where I don’t necessarily follow Dave Ramsey’s method. I acknowledge that Dave’s method is psychologically powerful; especially, when you’re able to eliminate your first debt quickly. However, my preference is for the more mathematically efficient method of paying off your highest interest debt first.

Again, there is no right or wrong way and either method will serve you well.

Here are a few articles that discuss Baby Step 2

Baby Step 3: Three to six months of expenses in savings

Now that your debts are paid off, Dave Ramsey puts you on a fast track to build your financial security. This is where you add everything you can to your emergency fund so that you’ll have a bigger cushion against emergencies.

I agree with Dave here with two differences. First, I think a bigger emergency fund is necessary in this economic condition, because it’s taking longer than 6 months to find a new job. Second, my preference is to keep money in a high interest savings account as opposed to money market account.

Here are a few articles that discuss Baby Step 3

Baby Step 4: Invest 15 percent of household income into Roth IRAs and pre-tax retirement

By this time, you have no debt except for the house (if you own one) and a large enough emergency fund to cover 3 to 6 months of your living expenses.

Step 4 is the first step in your journey toward wealth building.  As you read step 5 and 6, you’ll notice that Dave Ramsey advocates a balanced approach to wealth building where you are dividing your money among investing, paying off your home early, and saving for college.

Counterpoints

For this step there are several key counterpoints I’d like to make

  • 15% will depend on your age — I think 15% is a good guideline. However, you’ll need to save considerable more if you have less than 35 years to invest for your retirement; and less if you’re starting young. Why age matters? Because you need time for compound interest to work. If you need more proof, here’s an article that shows you the effect of 10 years have on compound growth.
  • Traditional 401k versus Roth IRA — If you don’t have an option of investing in a Roth 401k, I wouldn’t overlook traditional 401k. At the minimum, invest enough in 401k to fully capture your company’s matching contribution. Once you do this, Roth IRA is the next best thing.

Here are a few articles that discuss Baby Step 4

Baby Step 5: College funding for children

If you have children that will be going to college (or if you want to go back to college yourself), Dave’s plan encourages you to save some of your income toward college savings. Dave doesn’t want you to save for college using insurance, savings bonds, zero-coupon bonds, or pre-paid college tuition. Instead, he recommends Education Savings Account (ESAs) and 529 plans.

How much to save?

I think the answer depends on many factors. Like Dave, I want to emphasize that saving for your retirement takes precedence over saving for your children’s college expenses. As a guideline, I think it’s fair if you can help your children fund 2 years of public college, 4 years of public is good, and 4 years of private is more than necessary. Here’s a good article that discuss if you should pay for your children’s college education or make them work for it.

To figure out the right amount for your situation, follow along this article to determine how much to save college. However, I should note three changes I’ll be making to that plan here:

  • I think it’s safer to assume 6-8% return rate at this point. I don’t think we will see the 10-12% return rate we have seen in the past.
  • The plan should account for increasing bond-to-equity ratio as your child approach college age with the ratio being 100% fixed-income investment by the time he’s a senior in high school. This will prevent any kind of catastrophic loss as we are seeing now.
  • The return rate needs to be lowered as the year progress to account for greater bond-to-equity ratio.

Counterpoints

I’ve discussed Dave Ramsey’s college advice in the past. Although the argument against Dave is less relevant now, the article still serves as a good starting point to understand the difference between an Education Savings Account (ESAs) versus a 529 plan.

Here are a few articles that discuss Baby Step 5

Baby Step 6: Pay off home early

If you are able to do everything prescribed so far, Dave wants you to think about paying off your home mortgage sooner (as opposed to increasing your investment contribution or adding more to college savings for your children).

Key points that Dave makes regarding this step includes:

  • When selling a home, think like a retailer.
  • When buying a home, think like an investor.
  • Never get more than a 15-year fixed mortgage.
  • Don’t tie up more than 25% of your income in house payments.

Counterpoints

I think this step works well for many people. It’s certainly a good and balanced approach if you’re also investing and saving for college at the same time. Certainly, I would not advocate paying off your home early if you have to sacrifice the other two.

However, I want to encourage you to look at all the pluses and minuses of paying off your home early before you dive into this step — especially if you are an experienced investor. Also, I believe that prepaying your home mortgage is NOT the best option in this economy.

Here are a few articles that discuss Baby Step 6

Baby Step 7: Build wealth and give!

At this point, you’re in better financial shape than ever. And it’s up to you to continue to build on the momentum and grow your wealth. Also, you are now in a position to give — whether it’s your money or your knowledge — giving is a good thing.

Here are a few articles that discuss Baby Step 7

Additional Dave Ramsey’s Baby Steps Resources

So there you have it — Dave Ramsey’s Baby Steps in a nutshell. With this plan as a template, you’re now ready to beat credit card debt, build up your emergency fund, invest for your retirement, save for your children’s college education, and build wealth.

Reviewed and updated March 12, 2011.

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Source: A Review of Dave Ramsey’s Baby Steps To Financial Freedom from Moolanomy Personal Finance, written by Pinyo.

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