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.
Photo by billerr via Flickr
Dave Ramsey’s Baby Steps
Dave Ramsey’s financial plan includes 7 steps:
- $1,000 to start an Emergency Fund
- Pay off all debt using the Debt Snowball
- Three to six months of expenses in savings
- Invest 15 percent of household income into retirement savings
- College funding for children
- Pay off home early
- 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 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.
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 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.
Articles that discuss Baby Step 0
- Baby Step 0 – No More Debt at Single Guy Money
- Dave Ramsey’s 7 Baby Steps By The Numbers: Getting Started at Bible Money Matters
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 build 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 how to earn more money.
Where to keep your emergency fund
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.
Articles that discuss Baby Step 1
- Baby Step 1 at Dave Ramsey
- Dave Ramsey Baby Steps Step 1: $1000 Emergency Fund at Gather Little By Little
- Dissecting Dave Ramsey’s Baby Steps: Baby Step 1 at No Credit Needed
Baby Step 2: Pay off all debt using the Debt Snowball
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).
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 some ways you can reduce the interest rates on your loans so that more of your payments go to reduce principal amounts:
- Call your lenders and ask for a lower rate.
- Transfer debt from higher interest rate accounts to lower interest rate accounts.
- Get a bank loan to pay off high interest debts.
- Leverage low interest balance transfer credit cards.
- Borrow from peer-to-peer lending networks to consolidate and pay down your high interest debts.
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.
Articles that discuss Baby Step 2
- Baby Step 2 at Dave Ramsey
- Dave Ramsey’s 7 Baby Steps: Step 2 – Pay Off All Non-Mortgage Debt Using The Debt Snowball at The Christian Dollar
Baby Step 3: Three to six months of expenses in savings
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 because it could take a long time 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.
Articles that discuss Baby Step 3
- Baby Step 3 at Dave Ramsey
- Step 3: Fully Funded Emergency Fund at Being Frugal
- How and Why to Start an Emergency Fund at Get Rich Slowly
Baby Step 4: Invest 15 percent of household income into retirement savings
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:
- 15% depends on your age — I think 15% is a good guideline. However, you’ll need to save considerably more if you have less than 35 years to invest for your retirement. Conversely, you need to set aside less if you start young. Why does age matter? Because you need time for compound growth to work. If you need more proof, I offer an article that shows you the effect 10 years has on compound growth.
- Traditional 401k versus Roth IRA — If you don’t have the option of investing in a Roth IRA, don’t overlook the traditional 401k. At minimum, invest enough in your 401k to fully capture your company’s matching contribution. Once you do this, the Roth IRA is the next best thing.
Articles that discuss Baby Step 4
- Baby Step 4 at Dave Ramsey
- Dave Ramsey’s Step #4: A Visual Guide to Saving 15% for Retirement in a Roth 401(k) at The Dough Roller
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 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.
How much to save
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:
- 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 approaches college age, with the portfolio composed entirely of fixed-income investments by the time your student is a senior in high school. Shifting the asset allocation of the college plan can protect the portfolio against catastrophic loss in the event of another stock market crash just before your child heads to college.
- Account for a lower return rate as the years progress to account for greater bond-to-equity ratio.
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.
Articles that discuss Baby Step 5
- Baby Step 5 at Dave Ramsey
- Dave Ramsey Baby Step 5 – College Funding For Children at My Two Dollars
- How much to save for a baby’s college education? at Sense to Save
- Saving Money for College- Education Savings Accounts and 529 Plans at Think Your Way To Wealth
Baby Step 6: Pay off home early
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:
- 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.
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.
Articles that discuss Baby Step 6
- Baby Step 6 at Dave Ramsey
- You should NOT pay off your mortgage early at How to Make 7 Million in 7 Years™
- How To Pay Off Your Mortgage Early at The Greenest Dollar
Baby Step 7: Build wealth and give!
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.
Articles that discuss Baby Step 7
- Baby Step 7 at Dave Ramsey
- Dave Ramsey’s step 7: live and grow rich! invest in mutual funds and real estate at Plonkee Money
Additional Dave Ramsey’s Baby Steps Resources
- Dave Ramsey’s 7 Baby Steps at Cash Money Life
- Evaluating Dave Ramsey’s Total Money Makeover — Which Baby Step is Right for You? at Mrs. Micah
- Dave Ramsey’s Baby Steps To Financial Success at The Digerati Life
- Dave Ramsey’s Baby Steps Review at The Happy Rock
- A Deeper Look At Dave Ramsey’s Seven Baby Steps To Financial Freedom – And How They Apply To Us at The Simple Dollar
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.
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.