Dave Ramsey’s baby steps have helped thousands of people to become debt free while giving them the tools they need to completely reshape their financial picture. There’s no question in my mind that Dave is one of the best financial motivators out there. His radio show, books, and course Financial Peace University inspires people all over the country to change the way they handle their money.
In his book Total Money Makeover, Dave Ramsey shares his 7 baby steps, which act as a foundation for much of his personal finance material. If you haven’t read the book, I’d encourage you to pick it up. It’s full of inspiring stories that really drive his suggestions home. In a nutshell here are the 7 baby steps:
Dave Ramsey’s 7 Baby Steps:
- Baby Step 1: Create a $1,000 Emergency Fund
- Baby Step 2: Pay Down All Debt With the Debt Snowball
- Baby Step 3: Save 3 to 6 Months of Expenses in Savings
- Baby Step 4: Invest 15% of Income into Roth IRAs or pre-tax retirement
- Baby Step 5: Fund College Savings for Children
- Baby Step 6: Pay Off Your House Early
- Baby Step 7: Build Wealth and Give
Do These Baby Steps Actually Work?
Don’t let the simplicity of these baby steps cause you to think that they won’t work for you. A recent study by a Harvard University professor found that nearly half of all Americans could not come up with $2,000 within 30 days if they needed to. Achieving the third baby step would put you ahead of half the country!
As we dive into each of the steps, you’ll see why they work and how you can tweak them to fit your family. Will everyone’s journey through the baby steps be the same? Not at all! But you’ll never know how much better your finances can be if you don’t attempt them, so let’s start with baby step 1.
Baby Step 1: Create a $1,000 Emergency Fund
If you’re living paycheck to paycheck, every unexpected expense can feel like a major battle. Life just happens, and it usually comes with a price tag! Flat tires, dead air conditioners, and broken washing machine are just a few things that usually end up on credit cards because the money just isn’t there.
I know what you’re thinking. 1. How am I going to come up with $1,000? 2. Is $1,000 really going to make a difference?
Yes, pulling $1,000 out of thin air is tough. But think back to the last big purchase you made. How did you get the money for that? What about side jobs, overtime, or things that you’ve sold around the house? This initial step calls for creativity. For some inspiration on how to make extra money, take a look at these articles:
Secondly, $1,000 may not cover every expense, but I guarantee it’ll help cover most of those pesky unexpected expense that ends up on a credit card. Even more importantly, there’s just a feeling of preparedness that comes when you have a small emergency fund. It lets you focus on paying down debt with confidence, which leads into the next baby step.
Baby Step 2: Pay Down All Debt With the Debt Snowball
Now that you have an emergency fund, Dave Ramsey suggests that you attack your debt with gazelle intensity. Indebtedness is one of the worst feelings in the world, especially when you’re barely able to make the minimum payments. That’s why the Debt Snowball is the key to mastering this baby step.
The basic idea behind the debt snowball is to achieve small wins and work your way to bigger and bigger wins.
It all starts by listing out all of your debts by payment amount (everything but your mortgage). List them from smallest to largest payments – do not take interest rates into account. The debt with the smallest balance should get the most attention including every extra dollar that you can put towards it. Maintain the payments on your other debt and pay down the smallest balance first.
When the debt with the smallest balance is finished, you’ll not only be more motivated than ever, but you’ll have extra money to apply towards the next largest payment. This is the snowball effect and it really does work. While some people have criticized it because it doesn’t take interest rates into consideration, the psychology behind it makes it a powerful way to pay down debt.
If you want to start on the debt snowball, here’s a spreadsheet that will make it easier for you to track your progress.
Baby Step 3: Save 3 to 6 Months of Expenses in Savings
Once you’ve paid off all your debt (minus the mortgage), it’s time to beef up your emergency fund. The third step is to save 3 to 6 months of expenses in a savings account. For many families, that might mean saving $6,000 to $12,000. The very thought of that might seem impossible, but if you no longer have debt payments to make, you can apply the money towards your savings account. Sure, it might take a good six months to a year to fully fund your extended emergency fund, but it’s a critical step.
I really can’t stress the importance of having enough to cover 3-6 months of expenses. If you were to suddenly lose a job, you could end up in the same debt situation as before if you don’t have enough in savings. Worse yet, you might be forced to draw from your retirement account, which means a 10% penalty and lack of retirement assets in the future.
If you need help automating your savings and want it to be invested for growth, look at the options at Betterment. We’ve shared how simple Betterment is when it comes to investing, but it’s even better (see what I did there? :) ) for helping you to automate your savings. You can set a monthly draw straight from your bank and have it invested automatically. With the ‘goals’ feature at Betterment, you can categorize your savings as ‘emergency fund’ or ‘3-6 months of expenses’ with a few clicks.
Baby Step 4: Invest 15% of Income into Roth IRAs or Pre-tax Retirement
Right now, saving 15% of your income for retirement may seem impossible. But remember, the whole point behind these steps is to get you to the point where you have the cash flow to achieve every next step. Once your debts are paid and your 3-6 month emergency fund is set, Dave Ramsey suggests that you shift your attention to saving at least 15% towards retirement. He also recommends that you use a Roth IRA or a pre-tax retirement account. Here are a few articles to explain the differences with retirement accounts.
While I agree with Dave when it comes to saving as much as you can towards retirement, we don’t agree on one thing – investment return expectations. Dave Ramsey’s 12% expectation isn’t a healthy expectation to have. A more realistic expectation is between 7-9%. Use this as a guide and you’ll be pleasantly surprised if your returns do better.
Baby Step 5: Fund College Savings for Children
Dave is a big believer in attending college debt free. It is possible if you plan ahead and make sacrifices. If you have children and want to contribute to their education, you should look into two types of savings vehicles: 529 college savings plans and ESAs (Educational Savings Accounts). ESAs are available at many banks and financial institutions and allow you to save up to $2,000 per year for your child’s future education. A better option is to look at your state’s 529 college savings plan. A 529 college savings plan will give you much more flexibility in terms of maximum contributions, investment options, and tax breaks. With both accounts, your investment grows tax-free and the funds can be used for educational expenses without being taxed.
In my opinion, I think saving for college is good thing, but don’t put it ahead of your retirement savings. Remember, your child can borrow for college, but you cannot borrow for retirement. While I wouldn’t encourage your child to turn to loans right away, they can find resources through scholarships, financial aid, work-study, part time jobs, and internships.
Baby Step 6: Pay Off Your House Early
Your home is most likely your biggest debt. Dave wants you to be free of all debt, including your home, so he emphasizes this step no matter how old you are.
Not having a mortgage payment can be really freeing. Imagine how your monthly expenses would drastically change without paying rent each month!
The only hole in this baby step is the concern of the still-uncertain housing market right now. For a family that does not plan to stay in a home for more than 5 years, putting every extra dollar towards the mortgage may not be such a good idea. If you are fairly certain that you’ll stay in your home for a long time (5+ years), and have adequate funds going into an investment account (baby step 5), then paying down your mortgage early might be a good plan. I’d suggest that you consult with a financial planner if you’ve successfully reached this step.
Suggested reading: Should I Rent or Buy a Home?
Baby Step 7: Build Wealth and Give
How exactly do you build wealth? There’s no doubt in my mind that your financial perspective will change for the better when you implement these baby steps. Your new approach to managing money and automating your savings will create wealth faster than you could imagine.
The key to building wealth has little to do with how much you make and everything to do with how much you spend and save. These baby steps will reshape your spending and saving habits and put you on a path to build wealth like no one else.
Dave also emphasizes the fact that you’ll be able to give like no one else when you experience the financial freedom that comes after completing the baby steps.
Final Thought on Dave Ramsey’s Baby Steps
The reason I like the 7 Baby Steps so much is that it’s designed to keep you focused. It’s so easy to lose focus when you have a lot of debt and unexpected expenses, which is why I believe a lot of people fall into credit card debt so quickly. When you work to complete each step, you feel a sense of accomplishment, which pushes you towards the next goal.
If you’re thinking about starting these 7 baby steps, I’d encourage you to start right away. If you need encouragement, pick up Dave’s book Total Money Makeover and read the success stories in it. There’s no reason why you cannot be a success story too! What are you waiting for?
Have you worked through Dave’s 7 Baby Steps before? Share your success or progress in the comments!