- Dave Ramsey’s 7 Baby Steps are designed to simplify financial planning.
- Mistakes are possible and could worsen your financial position.
- Learn what to avoid to succeed at Dave Ramsey’s 7 Baby Steps.
Personal finance personality Dave Ramsey is the author of the bestseller Total Money Makeover and proponent of a money management plan called the 7 Baby Steps. Countless consumers have used Dave Ramsey’s 7 Baby Steps to turn their finances around.
However, the program isn’t going to work for everyone, and many experts believe that it isn’t even the best way to achieve financial freedom. Here are some dos and don’ts to follow when working through the 7 baby steps, according to personal finance specialists.
|Baby Step||Action to take|
|1||Save $1,000 for your starter emergency fund.|
|2||Pay off all debt (except your mortgage) using the debt snowball method.|
|3||Save three to six months of expenses in an emergency fund.|
|4||Invest 15% of your household income for retirement.|
|5||Save for your children’s college fund.|
|6||Pay off your home early.|
|7||Build wealth and give.|
Baby Step 1
Ramsey’s first step is to save $1,000 for your starter emergency fund.
“The reason $1,000 is recommended is because that amount can cover most emergencies. Consider that only 36% of Americans say they can pay cash for a $400 emergency – that means most people are borrowing, selling, or going into debt when life happens,” says George Kamel, a personal finance expert for Ramsey Solutions in Franklin, Tennessee.
Robert Johnson, professor of finance at Creighton University in Omaha, Nebraska, recommends making emergency savings automatic.
“For instance, have an amount taken out of each paycheck and put directly into an emergency savings fund – it should be a very low-risk account, like a bank savings account or money market fund,” he says.
Of course, it can be challenging to set any money aside if you are on an extremely tight budget, notes Melanie Hanson, editor-in-chief of EDI Refinance.
“If you really have to stretch your budget to get this $1,000 saved as quickly as possible, it may not last,” she says. “It may be better to contribute what you can comfortably manage and get there slower than to overstretch your budget to achieve this goal.”
Baby Step 2
Ramsey’s second step is to pay off all debt (except your mortgage) using the debt snowball method.
This method calls for paying off your tiniest debts first so that you get them out of the way; then, you can work off bigger debts in ascending order.
“Start by listing on paper all your debts, from smallest to largest, regardless of interest rate – except your house. Then, start tackling the smallest at first,” advises Kamel. “You should make the minimum payments on every other debt. But for your smallest debt, pay as much as possible toward paying it off in full until it is gone. The snowball method works because it’s all about changing your behavior. Once your smallest debt is paid off, all that money rolls into the second debt, and more money means more snow.”
Keep in mind that you’ll need more financial wiggle room to pay extra on a single debt every month, as the more you can pay, the faster that debt will shrink.
“This method only works if you are not taking on more debts. Try to avoid major purchases that require financing, if possible,” Hanson adds. “It’s also important to consider things like interest rates and early payoff penalties with some debts.”
Alternatively, consider applying the avalanche method, which recommends making minimum payments on all of your outstanding debts each month, after which you can apply any leftover money toward paying off debts with the highest interest rates. This will ultimately save more money otherwise paid toward interest.
Baby Step 3
Ramsey’s third step is to save three to six months of expenses in an emergency fund.
The goal here is to beef up your savings so that you can withstand unexpected events that may come your way – such as a job loss, per Kamel.
“The general rule of thumb is you want to figure out how much money you would need if your regular income went away,” Kamel continues. “For single-income households, aim for six months of expenses. Two-income households can aim for at least three months.”
“Most financial advisors prescribe putting aside at least six months’ worth of expenses toward emergency savings,” explains Johnson. “These funds should probably be very conservatively invested, such as in a bank savings account or money market fund account.”
Three to six months’ worth of expenses saved “can yield a significant rate of return if you put it into a higher-yielding savings account of some sort,” Hanson agrees.
Don’t beat yourself up if you can’t save three months’ worth of expenses; save what you can, as something is better than nothing.
Baby Step 4
The fourth step in Ramsey’s strategy is to invest 15% of your household income for retirement.
“Investing in retirement accounts is something people should do as soon as they start working. The biggest mistake many people make is not taking enough risk,” Johnson suggests. “The surest way to build true long-term wealth for retirement is to invest in the stock market.”
If you have access to a 401(k) and matching funds at work, don’t defer saving for retirement while you aim to get six months of emergency funds together. You’re forgoing free money if you do that.
“You definitely want to be using tax-deferred accounts like an IRA and a 401(k) if your employer offers them. The money in these accounts should be invested in mutual funds, ETF’s, or index funds for the most part,” recommends Hanson. “Choosing the right investment mix and tax savings are important here. Ramsey’s previous steps focused primarily on your ability to save a little money each month. Now you have to make informed decisions on what to do with those savings.”
Just be aware that you may have to pay third-party fees for any actively-managed retirement accounts.
Baby Step 5
Saving for your children’s college fund is Ramsey’s step #5.
This step can be skipped if you don’t have any offspring. “Otherwise, it’s time to start researching and stash money away for your kids’ education,” says Kamel. “Look at opening an educational savings account or a 529 college savings fund. Have early conversations with your kids about college so that you can better ensure these funds go to good use.”
Be careful that you don’t overinvest in your child’s future education to the detriment of your retirement savings. You should prioritize the latter more than the former.
“Your kids may or may not go to college, but you will absolutely want to retire. You are not a bad or selfish parent to put your retirement first – it’s a wise move,” Kamel adds.
Hanson cautions that the steeply-rising cost of college tuition as well as the chance that your child might not necessarily be college-bound can make this a slightly riskier investment.
“If you are not certain about your child’s future plans, avoid putting money into a 529 plan, as this can only be used to pay for education costs. Instead, consider mutual funds.”
Baby Step 6
Step 6 is to pay off your home early.
“By this point, you should be more comfortable with the power of the snowball method, as used in step 2. This is just putting that money to different use by making accelerated mortgage payments or paying extra on your mortgage each month – the more the better,” says Hanson. “You may even want to look into refinancing or other ways of changing the terms of your mortgage in order to pay it off even faster.”
One primary advantage of paying off your mortgage early is the peace of mind and financial freedom it will bring.
“You’ll have more flexibility to weather life’s setbacks. It also gives you the flexibility to fund other life needs and wants,” Johnson says. “The drawbacks of paying off your mortgage early is that your payments will be higher and may crowd out other investments – such as contributing to a retirement plan or funding a child’s college savings.”
Also, the opportunity cost of paying off a mortgage with a relatively low fixed interest rate (likely under 4%) when you can be earning around 10% by investing in mutual funds, stocks, and other equities, may not be a good decision for everyone.
“If the inflation rate is higher than the interest rate on your mortgage, you can actually make money by skipping to the next baby step,” Hanson advises. “If you are determined to pay down your mortgage early, be sure to look into early payoff penalties; they are more common on mortgages than on other forms of debt.”
Baby Step 7
Ramsey’s seventh and final step is to build wealth and give.
“Once you reach this step, you should be debt-free. All of your money is yours, and now you get to bless people in return by contributing to your favorite charities and worthy causes,” says Kamel.
Giving is a good idea but make sure you take care of things like medical, disability, and long-term-care insurance first, the experts suggest.
“Also, carefully investigate the charities, political groups, or other worthy causes you have targeted so that you know where your contributions are going to end up,” adds Hanson. “Inexperienced donors can be the easiest to take advantage of. Avoid any groups that appear suspicious or offers that feel too good to be true.”
Assessing the 7 Steps
Dave Ramsey’s baby steps can be worthwhile financial planning tactics that can help you live a debt-free life and position you to build wealth more quickly. But they aren’t foolproof.
“What I really like about Dave Ramsey’s 7 baby steps is how any individual can use them as a blueprint. The pace at which you achieve them will vary, depending on your circumstances. But each step is sound financial advice that you’ll be better off following,” says Nate Tsang, founder/CEO of WallStreetZen.
Johnson agrees that many of these baby steps have merit but cautions that tackling them one at a time may not work for everyone.
“These steps are overly simplistic. Taken individually, they are all sound ideas, but the way they are presented makes it appear that you complete one step at a time before taking the next step,” he says. “Unfortunately, this isn’t how financial planning often works. One simply can’t focus on one goal at a time, but instead one must juggle many goals and priorities.”
Kamel, however, is a true believer who claims that the 7 baby steps worked for him personally.
“I had about $40,000 in consumer debt in 2013; $36,000 of it was student loan debt and the rest was credit card debt. I decided I had to take control, so I started applying these baby steps,” he says. “I paid off all my consumer debt in 18 months and recently paid off my house. I can testify that the baby steps are successful for people if they follow the plan, get intense, and stay hopeful.”