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.
The followings are the seven steps in Dave Ramsey’s financial plan.
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.
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.
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.
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.
Despite the low interest rate, the best place to keep an emergency fund is in a good online savings account.
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.
The 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).
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:
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.
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.
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.
For this step there are several key counterpoints I’d like to make
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.
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’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.
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:
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.
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.
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. Lastly, you may also want to check out this article on Dave Ramsey’s Financial Peace University.
Reviewed and updated March 12, 2011.