Whereas Dave Ramsey’s Baby Steps have often been dissected one at a time, my goal in this post is to give an overview of the steps as a unit and explain why the order is essential.
Hopefully, these steps can help you create a focused life plan for your finances, regardless of your age or financial well being.
First, the Baby Steps:
- Step 1: $1,000 in an emergency fund.
- Step 2: Pay off all debt except the house utilizing the debt snowball.
- Step 3: Three to six months of savings in a fully funded emergency fund.
- Step 4: Invest 15% of your household income into Roth IRAs and pre-tax retirement plans.
- Step 5: College Funding
- Step 6: Pay off your home early.
- Step 7: Build wealth and give.
The Power of Focus
Dave’s premise with the Baby Steps is that people can accomplish great things IF they can just be focused. When you read over these seven steps, you think, “Yes. I need to be saving. But I also need to be investing for retirement. I should get my house paid off early. But I also need to be getting out of debt and saving for my kid’s college. You would readily agree that all of these goals are important for successful financial planning. The problem is that your stress level kicks into overdrive with the prospect of doing them all. You clench your jaw and do what you are capable of doing while feeling anxious about the goals you place on the back burner.
The Baby Steps plan works because when you stay focused on one step at a time, you can knowingly put some important goals on hold without the nagging feeling that you are leaving something undone. Why? Because accomplishing each step puts you in a great position to accomplish the next one. You begin to feel an empowerment and a sense of control as you get one step behind you and start the next one. You are making progress instead of treading water.
Why Are the Baby Steps in the Order They Are In?
Steps 1 and 2: $1,000 Emergency Fund and Debt Snowball
Notice that Steps 3 through 7 are all about using your money to do something positive for you and your family. Of course this money comes from your income, but the problem with most of America is that we are using our income on debt payments. Because we are paying others instead of ourselves, we need to get rid of our debt (Step 2) in order to free up our income for Steps 3-7.
Ask yourself, “What if I could use all the money I am currently paying to creditors to start “paying myself”? For many people this is $1,000 to $3,000 a month.
Baby Step 2 debt snowball is designed to do just that. Step 1 is necessary before Step 2 because you don’t want to start paying off debt without having a small cushion to absorb the little unplanned expenses that will occur during Step 2.
Step 3: 3 to 6 months of Savings
After completing the first two steps, you are out of debt (except for your house) and now have that cash flow you dreamed about: all of the money you used to pay others is at your disposal. The temptation is to start investing for retirement or saving for your kids college or pay off your house early. NOT SO FAST! You will get to those, but doing so prematurely is way too risky.
Stop, take a deep breath and use that cash flow to build up your emergency fund so you will indeed be ready for emergencies. This fund needs to be liquid (in a savings account or money market account). If you skipped the step and started any of the ensuing steps, how would you handle emergencies? Pull money from your retirement account? Rob the kid’s college savings? Borrow money against your house? All bad ideas. Step 3 is therefore always ahead of the following steps.
Steps 4, 5, and 6: College Funding, Pay Off Home, Build Wealth and Give
You may be asking,
“Why is retirement ahead of college funding? Wouldn’t a good parent put his children ahead of himself?”
Good question. But what if you end up without sufficient retirement income because you made college funding a higher priority? Who will you be depending on in your later years? Your kids! The thing about retirement planning is that you only get one shot at it. The years go by and you will someday be retirement age. You don’t have a choice. On the other hand, college funding is full of choices: kids can get scholarship, they can work, they can attend community colleges, they can find work/co-op programs, etc, etc.
Step 4 is therefore ahead of step 5. But notice that Step 4 is 15% of your income. If you have cash flow greater than 15% you can apply that to college funding immediately, and if you have more than enough cash flow to accomplish both steps 4 and 5, you can use all of the extra to pay off your house early (step 6). Note that Step 6 comes behind retirement and college funding because reversing the order could possibly give you a paid for house at the expense of a dignified retirement or helping your kids through college. Most of us wouldn’t want that.
Here are some great investing tips for beginners.
Step 7: Build wealth and give.
Life is now very good! You have no debt, a great emergency fund, and a paid for house. All of the cash flow that used to go toward debt reduction and house payments is now at your disposal. This, by the way, is the step Janice and I are on. Being semi-retired, we don’t have a huge income, but it is very sufficient because we also don’t have any debt. We continue to invest every month and we are able to give more than we have ever given before.
Once we got our house paid off, we started to budget “bless” money, which we put into an envelope every month just to have available so we can bless others as we see the needs. We are also able to help our grown daughter and daughter-in-law cash flow their college.
As I said, life is good. Janice and I are experiencing great financial peace and we are very grateful for Dave Ramsey’s Baby Steps.
I wish the same for you.
This article is a general overview of what Dave Ramsey has to offer and is not intended to replace his course, nor is this sponsored or endorsed by Dave Ramsey or the Lampo Group.