I've written before about some ways in which Dave Ramsey may be misleading you. For the most part, however, I think he gives great advice, especially with regards to the behavioral issues relating to getting out of debt and dealing with family and small business financial issues. One of the pearls Dave has contributed to the personal finance lexicon are his “Baby-Steps.” They seem aimed at the financially clueless, but they still have merit for the more knowledgeable. I introduce them in this post.
Baby Step 1 – Build up a $1000 Emergency Fund
According to Bankrate, 30% of Americans have no money at all. Literally, there is no savings account, CD or anything like it. Meanwhile, Americans have $785 billion in credit card debt. Divide that by 114 million households, and you're left with $6886 in credit card debt per household. With the median household income being $51,400, that suggests that the typical American has an emergency fund of NEGATIVE 1.6 months. [Update 2018: Americans' total revolving debt is now over $1 trillion dollars, the average credit card balance is $6354, median household income is over $57,617, and only 39% have enough savings to cover a $1000 emergency. — Ed]. Getting $1000 in a bank account is a vast improvement. It allows the household to avoid racking up more debt for relatively minor emergencies- small medical bills, broken appliances, car repairs, minor home repairs, airplane ticket to a funeral etc.
Baby Step 2 – Pay Off all Debt (Except Mortgage) Using the Debt Snowball
I don't know if Dave Ramsey is the originator of the “debt snowball” idea, but he is certainly most responsible for popularizing it. The idea behind the debt snowball is that you pay your debts off in order from smallest to largest, without regard to the terms or interest rates of the loan. This is a purely behavioral approach to the problem, and Dave has been appropriately criticized for making an incredibly gray issue seem black and white. He advocates that this approach helps the debtor “feel success” and “gain momentum” so he is more likely to complete the process and get out of debt. If you examine the numbers from a mathematical perspective, you quickly realize that if you put the same amount toward debt repayment each month, you'll be out of debt sooner by paying down the highest interest loan first. Sometimes, especially with low-interest debt, you may be better off not paying the debt down any faster than you have to and using that money to invest in risky or even low-risk investments.
You can also argue that despite interest rates, some debt is worse than others. For example, student loans can't be discharged in bankruptcy. That's a good reason to get rid of them or exchange them for other types of debt whenever possible. It also doesn't consider the tax-deductibility of some types of interest. At certain incomes (usually less than doctors make) student loan interest is deductible, even if you don't itemize. Mortgage interest is also tax deductible if you do itemize, lowering the effective interest rate owed.
But it's pretty hard to argue that you should build up a larger emergency fund, save for retirement, or begin saving for college when you're paying interest of 15-30% on credit card debt. Even at rates well below 10% (think student loans), it might be worth forgoing tax-advantaged retirement savings in order to get the risk-free “return” that debt repayment provides.
Baby Step 3 – Put 3-6 Months Worth of Expenses in Savings
This is a pretty standard piece of personal finance advice, but I confess I've never actually had a dedicated emergency fund with 3 months worth of expenses in it. It seems every time I get close that I find something that I want to invest it in. It just didn't ever make sense to me to not max out a Roth IRA in order to fund an emergency fund. I figure I can always withdraw the contribution tax and penalty-free if I really need it. Likewise, I hated to pass up a significant tax break in order to put the money into an emergency fund. Do I really want to pay an extra $5K in taxes in order to have $15K in an emergency fund instead of my 401K? Not really. Our emergency fund gradually grows, but so do our expenses, so we've never actually hit the 3-month mark. It doesn't bother me much anymore. At a certain point, you don't need an emergency fund. A retiree living off his portfolio has the entire portfolio as an emergency fund.
Do I think you absolutely need 3-6 months of savings before investing anything? No. But you probably need a larger emergency fund than $1000. It can take a very long time to acquire an emergency fund of 6 months expenses. Imagine someone who pays 20% of their income in taxes, and is putting 15% toward an emergency fund, with plans to invest that toward retirement after the emergency fund is complete. To make it easy, we'll assume they make $100K a year. So their emergency fund needs to be $100K*65%*0.5= $32,500. Saving $15K a year means it'll take 26 months to fill that emergency fund. That's a long time to put off investing. I like the concept. I don't like the rigidity of having to complete one step before starting on the next one.
Baby Step 4 – Invest 15% of Household Income into Roth IRAs and Pre-Tax Retirement
I generally recommend to readers on this site that they put 20% of their income toward retirement. But 15% is in the ballpark and is probably plenty for someone who starts early and doesn't plan to retire early. Dave's advice here doesn't quite fit with what I've criticized before- namely Dave's mistaken idea that “good growth stock mutual funds” reliably earn 12% a year on average. If your investments REALLY earned that much, you could save far less than 15% a year. (assuming 40 years of saving and guaranteed 12% nominal returns you could save as little as 1.3% per year thanks to compound interest.) But they don't, so you need to save 15%-20%.
Baby Step 5 – College Funding for Children
I think Dave got this one right on. You need to take care of yourself first before worrying about your kids. Eliminating the burden of supporting you in your old age is far more valuable than providing a few thousand toward their college costs. I'm surprised how many people make this mistake. You can't get loans for retirement, but it's easy to get them for education. Plus, if you've got retirement on track by the time the kids get into college (usually when you're around 45-50), you can easily cut back a bit on retirement savings and help pay for their college with your monthly cash flow. Compound interest and the time value of money make it far better to cut back on your retirement savings when you're 50 than when you're 35.
Baby Step 6 – Pay off Home Early
I don't have a problem with this advice either. Since mortgage rates are usually pretty low, and the interest is often completely tax deductible (my effective mortgage rate is 1.8%-below the rate of inflation), even a rabid anti-debter like Dave Ramsey recognizes that sometimes it may be smarter to invest rather than eliminate debt. There are benefits to paying off a mortgage early, including the psychological feeling of being debt-free, but also the financial freedom of lower fixed expenses and the elimination of the risk of losing your house to the bank in the event of misfortune.
Baby Step 7 – Build Wealth and Give
I also agree with Dave that giving away money is important. There is a lot of variability here. Many people give away 10% or more of their income each year, even when they don't make that much. Yet there are also plenty of high-income people who give away little more than a few hundred dollars a year. I'm always interested to see the percentages that presidential candidates give away when they publicize their tax returns. There are also a lot of people who don't give anything away until after their death. They figure they'll give away what they don't need, and can't know what they don't need until they're dead. It really comes down to your values.
I've got two problems with Step 7. First, what do you need to “build wealth” for if you've already got plenty of money for retirement and for college? Building wealth for the purpose of building wealth seems a bit miserly to me. I'd be happy to see Step 7 just be called “Give!” Second, as mentioned before, I dislike the rigid order of the baby steps. I guess I've completed Steps 1, 2, and 4, but I'm doing steps 3, 5, 6, and 7 simultaneously. The world is much more gray than black and white. I appreciate the structure provided by the Baby Steps (and suspect there are a lot of people who need it, especially the type that spends years on Step 2), but I think a more sophisticated view of personal finance is probably beneficial.
What do you think about Dave Ramsey's Baby Steps? How have they been helpful to you? Do you think they are too rigid? Comment below!
I personally don’t understand how people get so far into debt… my major money mistake was buying a car my excuse work was 2 miles away and while 3-5 months of the year i could easily walk.. during the winter -20 temps.. walking was not going to be fun. I spent 8k and could afford the payments until i was laid off… then i was screwed. I had been on track to pay off the car in 2.5 years instead of the 5. But the loss of a job set me back. I’ll never make the mistake of taking out a loan again. But to be 100k in debt? how is that even possible are people that dumb? My husband has 2 masters degrees and 0 debt. no one helped him. no loans just a job…. yup some people actually do that. work while in school Crazy i know! Our biggest money problem is wanting to buy a home. ideally with cash. we don’t want a mortgage, i like baby step 6 is it? lets just say that’s the step we where on ( use your imaginations) then following the steps we have $1000 a month to put toward a mortgage the average where we live is $1,300. btw my husband is a extremely frugal if its not spent on rent, food, heat we don’t spent it. you might think i am forgetting cloths but im not we might buy a new shirt or a pair of jeans if one pair is wore out but that amounts to maybe once a year
Funny that you think $100K is a lot. The average medical student now graduates with about $200K in student loan debt, at an average of 7-8% interest.
There are a lot of who can benefit from the baby steps i think my dad got me the book total money makeover almost 10 years ago now.. but he was also always good about teaching us how to spend and save wisely. unfortunately with my youngest sibling it didn’t stick. 12k in debt with student loans no degree. dropped out. :s
While she struggles to pay off the loans our biggest ‘problem’ is where to cut spending more do we can afford a home sooner. I was searching for more reasonable suggestions then ‘cut coffee once a week’ ‘bring lunch to work’ and the normal stupid suggestion most people give. we never eat out we always pack a sack lunch (even on road trips) and we never get coffee out side the home. anyway thats when i stumbled onto this site 🙂 full of more great advice that will help my husband and i to stay out of debt 😀
I am curious to find out what blog platform you happen to be utilizing?
I’m having some minor security issues with my latest blog and
I’d like to find something more safeguarded. Do you have any suggestions?
There is one glaring mistake in your article that throws your whole argument off. You save 3 to 6 months of expenses, not income. That means mortgage, utilities, gasoline and so on. My wife and I spend about 3,000 per month in expenses. That means if we lose our income, $18,000 will allow us to live for 6 months without having to work. Assuming we make $7,000 per month and have $3,000 in expenses, we will have $4,000 left over. That means a six month emergency fund will be complete in 4.5 months. If you choose to have a 3 month emergency fund, it will take approximately two months. That’s not too bad when you think about it.
Thanks for your insight… M
I agree if you save 57% of your gross income that you can save up an emergency fund very quickly. I’m not sure you realize how unique you are in doing that. If you keep that up, you’ll be financially independent very quickly as well. But I don’t think any of that is a “glaring mistake that throws my whole argument off.”
I do not like one size fits all financial advice. I am paying my mortgage off even though I have smaller loans like car and credit card. Ramsey uses extreme examples. His talks about 7% auto loans, 20% and above credit card rates, 12% returns on investments, and never mentions age which play a huge factor in financial plans. I pay a rate of 2.9% in auto loans and a 6% rate on my credit cards. Using average returns is worthless even if you say the average is 5%. You could average 10% returns over 3 years which means you make over 30% but in reality you only earn 10% total. Big difference from Ramsey’s example.
Paying extra each month on a mortgage will compound monthly and saves $10s of thousands in interest where paying extra on a car loan will save hundreds. If you are 30 and get a 30 year mortgage at 4%, inflation over time will make the monthly payment on 30-45% lower. If you are 50 and have a 30 year mortgage you should try to pay it off in 15 years.
Ramsey talks about saving 20% for a house. By the time most people can save $30k the house goes up another $20k. It would be better to buy a house ASAP and than pay a little extra each month. Paying the pmi for 5 years will be much less than the $10k – $20k the house appreciated while you were saving the down payment. Not to mention you are throwing money away on rent.
So explain to me why you’re paying extra on a mortgage when you have 6% credit card debts again? I missed the logic there.
“Throwing money away on rent” is a phrase used by the lending and realtor industry to promote home buying. You never heard “throwing money away on maintenance, mortgage interest, property taxes, or realtor fees” do you? Yet that money is thrown away just as much as rent money.
I’d argue that Physicians – and other high income earners – often need Dave Ramsey’s advice even more than most. Why? Because they tend to believe they can “out earn” their excessive purchases, exotic (or multiple) vacations, mortgage(s), loan burdens (from education expenses, and/or leased vehicles), and so on. Also, they are more likely (anecdotally) to have someone else “helping” with their investments, and are out-of-touch with what they even have. I teach Dave’s course and find that many of our high-income are in worse shape than the lower-income participants who are already more cognizant of – and carefully tracking – their expenses.
Your article for Step 3 leaves out one key factors Dave is teaching. You note it will take 26 months to save 3 to 6 months of expenses. If you’ve remove car debt, credit card debt, medical bill debt, etc. and are living on a budget you can reallocate those funds to step 3. The average is 6 months to complete this task, not 26 months as you suggest. So are you making a huge retirement or investment gain in a 6 month time frame? No. It makes perfect sense to complete this task BEFORE moving on so that it actually gets done. You then don’t need to tap into any investments to interrupt them working for you to handle an emergency, tax free or not because you have the money on hand. Additionally, Dave helps many, many doctors, not just common folk as many of the comments indicate. The debt snowball makes sense because of the emotional component involved. Many people aren’t math majors, but even if they are when it comes to money if you leave out the emotional aspect then you miss a huge component of exactly how money should be handled. Dave rightfully focuses on this area.
Yes, if you increase your savings rate, you can reach goals faster. If you save 50% of your net income, you can build a 6 month emergency fund in 6 months. If you save 75% of your net income, you can build it in 1 month. If you save 25% of your net income, it will take 18 months. If you save 15% of your net income, it’ll take 33 months.
People need to understand that at typical savings rates, it takes A LONG time to build up a 6 month emergency fund. There is some opportunity cost there. That’s why I’ve suggested some short cuts.