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Dave Ramsey’s Baby Steps to Financial Peace Review

Dave Ramsey’s Baby Steps to Financial Peace Review

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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 MakeoverFinancial 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 Baby Steps to Financial Peace Review 1

Dave Ramsey’s Baby Steps

Dave Ramsey’s financial plan includes 7 steps:

  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 retirement savings
  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 an excellent plan, it works, and it has helped 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 more on psychology than mathematics, and this is one reason why it works well for so many people.

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

The first 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 savings account — it is safe, accessible, and your money still earn some interest.

What I Would Do Differently

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 about Baby Step 1

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.

What I Would Do Differently

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. It uses the same framework, but you pay your highest interest debt first.

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 about 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 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 about Baby Step 3

Baby Step 4: Invest 15% 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.

What I Would Do Differently

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 invest less if you start young. Why does age matter? Because you need time for compound growth to work.
  • Traditional 401(k) versus Roth IRA — If you don’t have the option of investing in a Roth IRA, don’t overlook the traditional 401(k). At minimum, invest enough in your 401(k) to fully capture your company’s matching contribution. Once you do this, the Roth IRA is the next best thing.

Articles about 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 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;
  • good if you can fund 4 years at a public university, 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, you can start with this statistics from Value Penguin:

Average Total Cost of Public Colleges: $25,290 (in-state) $40,940 (out-of-state) Average Total Cost of Private Colleges: $50,900

Remember that college costs has risen about 3.64 times faster than inflation, or roughly 11% (source: Education Week)…so you have to calculate in the inflation to figure out the amount you’re aiming for.

For example, if you plan to pay for 2 years of in-state public college and your son will be in school in 10 years. Your goal is to save $25,290 x 2 and adjusted for 10 years of projected cost increase.

College Saving Goal = $50,580, or $115,224 (after 10 years increase at 11%)

That’s a lot of money…wow!

Articles about Baby Step 5

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.

What I Would Do Differently

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 either.

Articles about Baby Step 6

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 about 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 ready to beat credit card debt, build your emergency fund, invest for your retirement, save for your children’s college education, and build wealth.

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the weakonomist
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the weakonomist

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.

Christopher J.
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Christopher J.

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.

Jim
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Jim

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.

Dave
Guest

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

Al
Guest

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.

QOAS
Guest
QOAS

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

HS
Guest
HS

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

Roger
Guest

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.

Jason Unger
Guest

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.

Brandon
Guest

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… Read more »

Kate
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Kate

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.

SavvyMoney
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SavvyMoney

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.

rob
Guest
rob

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.

Jocelyn
Guest

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. 🙂

Priscilla
Guest
Priscilla

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… Read more »

James Parker
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James Parker

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

rob
Guest

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

KZK
Guest
KZK

I just joined SavvyMoney 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… Read more »

Kathleen
Guest
Kathleen

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… Read more »

Kathleen
Guest
Kathleen

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

Jillian
Guest
Jillian

I have read Dave Ramsey’s book. I agree with most of it. I dont agree with putting 15% of your income into a roth IRA right now. We are in a recession. We are going to do a double dip soon. All those people including me who trusted the government put $ into our IRA’s and 401K. Look what happened gone. So I am leary to trust banking institutions ever again.

Dave Ramsey’s Baby Steps to Financial Peace Review

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