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. But how practical are these steps? I offer a review of each step in the process so that you can decide whether or not Baby Steps will work for you.
Dave Ramsey’s financial plan includes 7 steps:
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 for a lot of people. It’s a good place to start if you’re looking to get out of debt and get your finances in order. Realize that Dave’s plan focuses on psychology more than 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 get into financial trouble due to bad luck, but most get there because they make bad financial decisions and engage in 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 how to earn more money.
Despite the current low-rate environment, 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; 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. The only exception is mortgage debt, which shouldn’t be included in your Debt Snowball. 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 some ways you can reduce the interest rates on your loans so that more of your payments go to reduce principal amounts:
I’m not a huge fan of the Debt Snowball. 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. You can follow the Debt Snowball technique, but start with your high interest debt rather than the smallest balance.
There is no “right” or “wrong” way to pay down your debt; do what works for you and is most likely to result in your success.
Now that your debts are paid off, Dave Ramsey puts you on the fast track to building 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 reservations. First, I think a bigger emergency fund is necessary in the current economic climate 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 a money market account, since many money market accounts come with inconvenient minimum balance requirements that can result in fees if not met.
At this point in the Baby Steps financial plan, 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 active wealth building. As you read steps 5 and 6, you’ll notice that Dave Ramsey advocates a balanced approach to wealth building. He suggests that you divide your money among investing, paying off your home early, and saving for college.
I offer several key counterpoints for Baby Step 4:
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 put 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.
As always, the answer to this personal finance question depends on many factors in your individual situation. 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 at a public university is good, and 4 years of a private college education is more than necessary. Here’s a good article that discusses whether or not you should pay for your children’s college education or make them work for it.
To figure out the right amount for your situation, use the guidelines in this article to determine how much to save college. However, I plan to modify the advice given in the article in three ways:
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 differences between an Education Savings Account (ESAs) and a 529 plan.
If you are able to do everything described 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. 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 you’ve ever experienced before. 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 ready to beat credit card debt, build your emergency fund, invest for your retirement, save for your children’s college education, and build wealth. You may also want to check out this article on Dave Ramsey’s Financial Peace University.