Dave Ramsey’s Baby Steps To Financial Freedom

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By Pinyo, on March 9, 2009

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 analyze 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 (you can use MoneyAisle to automatically search for best interest rate).

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, and use this article as a template to create your college savings and investment plan. However, I should note three changes I’ll be making to that plan here:

  • I think it’s safer to assume 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.

This article was featured in the Carnival of Personal Finance at Green Panda Treehouse, and Carnival of Twenty Something Finances at Pimp Your Finances.

Read more about

Emergency Fund, Dave Ramsey, Debt Reduction, college, baby steps, financial peace university, Debt Snowball, financial planning

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Pinyo
Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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27 Comments

  1. gravatar
    the weakonomist
    March 10, 2009, 2:31

    My biggest beef with step 4 is the expected return Dave touts for investing. He says you can expect to make 10-12% every year. Once you subtract fees, there is no mutual fund that averages 12% returns every year. So when he throws that into his calculations, he gets optimistic returns. Dave is great for debt reduction, but I really wish he’d adjust his investment numbers.

  2. gravatar
    Christopher J.
    March 10, 2009, 7:15

    heh… he claims to have a few funds that average 18% over time. And I don’t think he’s claiming that he gets that much of a return…he’s just stating the fund itself has that rate over a 10+ year period.

  3. gravatar
    Jim @ Change Jar Savings
    March 10, 2009, 8:56

    Nice summation. I have been reading Total Money Makeover. Like any advice, I think you should take what will work and use it and discard the rest. I personally have a baby step 1 without knowing it. It has saved me from using credit cards and paying interest. I would not skip that step ever again.

  4. gravatar
    Do You Dave Ramsey?
    March 10, 2009, 18:21

    As you might guess, I love hearing about Ramsey’s Baby Steps… I simply can’t get enough of them! Even if folks disagree with some elements or pieces of his approach, the overall concept is both brilliant and simple.

    Thanks for sharing!
    Dave

  5. gravatar
    Pinyo
    March 11, 2009, 11:06

    @Weakonomist – I agree, his numbers tend to be very optimistic. I was watching Dave Ramsey’s Free Car Video and the numbers are not realistic at all.

    @Jim – Yes, that’s the logic behind his $1,000 emergency fund; however, I prefer to save some finance charges using the $1,000.

    @Dave – No, really? ;-)

  6. gravatar
    Al
    March 12, 2009, 15:45

    I don’t agree with two points: The so-called debt snowball and the 15-year mortgage or less. The debt snowball will help you lose money by not paying the higher interest payments, as was mentioned in the counterpoints. Also, if you are stuck in a 15-year mortgage and fall on hard times, you can’t pay less. With a 30-year mortgage, you can always pay more.

  7. gravatar
    QOAS
    March 17, 2009, 14:56

    This is really an excellent list. I am beginning to plan my finances and your post served as a guide. Thanks!

  8. gravatar
    HS
    March 18, 2009, 12:03

    Dave is good for debt reduction, but I could never give up my credit cards, they provide so much freedom and I love the rewards.

    HS

  9. gravatar
    Roger
    March 22, 2009, 20:08

    Not a bad summary. I’ve never read Dave Ramsey’s books, but it seems like a logical, if occasionally flawed plan for success. I think the second step as Ramsey describes it is better for those who need a quick(er) psychological boost, while paying according to the interest that’s charged makes more sense for the logically minded among us.

    I’ll also second the sentiments about investing 15%; while it might be enough for someone with three decades or more before retirement, if you’re starting later in life, increasing the savings rate to account for the shorter time period is your best bet.

  10. gravatar
    Jason Unger
    March 23, 2009, 10:48

    Even though they’re a great way to teach people a process for financial success, I think the biggest thing flaw of the Baby Steps is that it doesn’t account for short-term savings.

    When are you supposed to save the money to buy a house? How about for a new car?

    His advice is good for people who are in financial turmoil, but for someone just starting out, it’s not entirely realistic.

  11. gravatar
    Pinyo
    March 23, 2009, 11:18

    @Jason – Nice catch regarding saving to buy a house. As far as a new car, Dave Ramsey advocates buying with cash. There’s a good video that explains Dave Ramsey’s Free Car For Life method. But if you’re good with money, you’ll notice a few inaccuracies. For example, ROI is too high, not accounting for taxes, registration, insurance, etc. However, it does convey the concept nicely.

  12. gravatar
    Brandon
    March 24, 2009, 1:01

    Great article. I love the “build wealth and give” step. For my wife and I, that’s our ultimate goal. To have enough that we feel like we can really make a difference. I’m not sure how I feel about paying off your house early though. If you bought a house at current interest rates (below 5%), you could be saving money in accounts that yield more than your mortgage rate. Hopefully HSBC, ING, and the rest of those online savings accounts will get back up to 6% and up where they belong.

    Actually, reading further it looks like you do mention that this step doesn’t necessarily apply to this economy. Hats off Dave – you nailed it.

  13. gravatar
    Kate
    March 27, 2009, 11:54

    Wonderful and very informative, thorough post! I like Dave Ramsey’s idea of baby steps for investing — kind of reminds me of a presentation I recently saw on a book called The Power of Small — but I agree with some of your objections to his strategy, particularly your point on paying off your debt before building your emergency fund. After all, as long as we owe money to someone else, the money we save isn’t really ours — it’s the lender’s.

  14. gravatar
    DebtGoal
    April 3, 2009, 19:57

    The question seems more an issue of how much to put into an emergency fund before reshifting focus back onto paying down debt. I think it depends on how much someone’s self-assessment of job security is, as well as the type of lifestyle they lead – it they are out drinking, playing high-risk sports, and traveling a lot, then a biggest emergency fund should be set up. But for the modest, a three-month emergency fund is a good bare-bones minimum.

  15. gravatar
    Pinyo
    April 9, 2009, 23:53

    @DebtGoal – Good point. It’s similar to investing in a way. You have to understand your ability, willingness and need to take risk, then make adjustment accordingly. It’s not one size fit all.

  16. gravatar
    rob
    April 13, 2009, 18:20

    Just becoming aware of Dave Ramsey, seen a presentation, just picked up the book. He is a great presenter, I like what he says. This article is also great to point out variations. I guess I got some thinking to do, but regardless of what path, or alterations I make, Dave has me motivated to attack debt and begin building wealth ‘ full force’ or Gazelle intense’ as he calls it.

  17. gravatar
    Pinyo
    April 14, 2009, 8:45

    @Rob – welcome to Moolanomy. Dave Ramsey is very popular debt reduction guru. Although his methods are not always the best mathematically, they works well for many people. In the end, you’ll have to find alternatives that work best for you.

  18. gravatar
    Jocelyn at I TAKE OFF THE MASK
    April 19, 2009, 1:19

    Baby steps could really mean a lot, especially in striving for financial freedom. It gives us specific goals to strive for and prevents us from being too overwhelmed by loftier goals. :-)

  19. gravatar
    Priscilla
    April 21, 2009, 17:01

    I’m trying to follow Dave’s guidelines. However, a few things don’t apply to me. I rent an apartment and I have about $45,000 in student loans. So I’m not sure where I fit in in all of this. Do I concentrate on step 2 and don’t do any of the other steps until $45,000 is paid off? That’s the only debt I have. Do I not contribute 15% to my Roth IRA until I pay the $45,000, do I not save for a home and continue to rent while I pay off the student loan? $15,000 of it is in private loans. Any advice?

  20. gravatar
    Pinyo
    April 21, 2009, 17:12

    @Priscilla – Interesting scenario and I am glad you asked. The answer is it depends on the interest rate you’re paying on your student loans. If you student loan is relatively cheap — i.e., less than 4-5% — it may be worthwhile doing other things and just pay the minimum on the loans. Here’s another article that might help you decide:

    http://www.moolanomy.com/1387/.....investing/

  21. gravatar
    James Parker
    July 23, 2009, 2:34

    Great and nice post this is fully all rounder post covering all sides! Good work

  22. gravatar
    rob
    August 30, 2009, 9:15

    For all those that did not follow this plan at least they still have a reverse mortgage as an option.

  23. gravatar
    KZK
    September 2, 2009, 20:50

    I just joined DebtGoal since I like how it gives me a visual of my goal. I’m already a fan of Dave. I wish they would make his steps a part of every high school education. It’s very hard for me to not beat myself up b/c of the mistakes I’ve made in the past.

    I just wanted to add my 2 cents to the order of the steps: I returned to work in 2008 after being home w/my kids for 7 years & therin grew the debt. So I started off paying down the debt but lost track b/c it was so nice to have 2 incomes again (dumb, dumb). Fast forward to tax time, & we got slammed. $8K. So in order to prevent the same thing next year, hubby & I are maxing our pre-tax 401k/403b payroll deductions. I was thinking I should pay off the debt 1st, but there’s no way that would make sense for us.

    I should point out that we don’t have a house (yet), another needed source of tax deductions………….!!

  24. gravatar
    Kathleen
    September 8, 2009, 15:01

    I’m following Dave Ramsey, and my financial house is getting into order, finally. I have a question for those of you who are more better at this than I am: I am working on Step 3, but I’ve already completed Step 4. I did them out of order. Should I now change things around, take the money I have that’s being directed into retirement and direct it instead into my 6 Months Savings step? I am 50 years old, just out of a 27 year marriage with zero savings besides my emergency fund. When I got my job two years ago I put the maximum allowable into all the retirement savings options I could because I am so far behind saving for the future. I am open to all advice. Thanks so much.

  25. gravatar
    Pinyo
    September 8, 2009, 15:07

    @Kathleen – Step #3 is a build on step #1 where you increase your emergency savings from $1,000 to 3-6 months worth of living expenses. If you don’t have one yet, I highly recommend that you start putting some money toward your emergency fund. As pointed out in the article, a high interest savings account is the perfect place for stashing your emergency fund.

  26. gravatar
    Kathleen
    September 8, 2009, 15:21

    I should have been more clear. I have completed Steps #1, 2 and 4. Should I go back and complete Step 3 before going on to Step #4 even though I’m age 50? Maybe take half of what I’m putting into retirement and apply it to the 3-6 months Savings?
    Thanks

  27. gravatar
    Pinyo
    September 8, 2009, 15:29

    Step #4 is an ongoing thing, so completed is a relative term. In any case, I assume your retirement savings is in some sort of an IRA account. If that’s the case, you can’t go back and withdraw your money prior to 59 1/2. If you do, you’ll have to pay the early withdrawal penalty and potentially taxes.

    In any case, you should have an emergency fund. The way to accomplish this now is by saving a little bit of money each month and put it toward your emergency savings as opposed to retirement savings. For example, if you have extra $100 at the end of each month and you were putting that toward your retirement savings, you could instead put it toward emergency fund savings until you have 3-6 months worth of living expenses — after which you could resume your retirement savings.

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