The following is an article by Travis from Christian Money Mountain.
Baby Step #1 -Save $1,000 to start an emergency fund
So, you’ve made the decision to get out of debt. Congratulations, it’s one of the best moves you’ll ever make. Just be warned, people will now think you’re weird. Going through Dave Ramsey’s 7 Baby Steps isn’t easy, and it goes against a lot of societal standards. I remember my friends always telling me “if you’re ever going to have anything in life, you have to go in debt”. But, the thing is, if you’re in debt, the stuff isn’t even really yours. You’re still paying someone for it, plus interest. Ok, on to the first step.
A Place to Start
What’s an emergency fund? It’s money you have set aside for those unexpected expenses that come up in life. It could be the heat/air going out in your house. It could be repairs to your car. An unexpected hospital visit or job loss. This is money to get you through those hard times in life.
You may be asking, couldn’t I just use my credit card. The answer is a loud NO! Didn’t we cut these up in my last post. Turning to credit cards when you have an emergency means more debt at a high interest rate. You’re $800 car repair can easily turn into $1,200 or more when using a credit card. Having an emergency fund allows you to pay for these expenses without paying someone else interest.
Will $1,000 be enough? It’s a good place to start. Whether it will be enough is really up to you. You could save $1,500 or $2,000, if it makes you feel more comfortable. Right now, I have a $2,000 emergency fund. The bigger your family, probably the more you want to have set aside.
Also, remember to keep your emergency fund readily available. I would suggest putting it in a high yield savings account (find the highest interest savings accounts here. This way your money is drawing a little bit of interest, but you can still get it whenever you need it. Just remember, this is not a fund to go out and buy a new tv because football season is around the corner. It is for legit emergencies.
Once, you have finished that step, you can move on to step #2. But whatever you do, don’t move on to step #2 until you have that emergency fund in place. Without the emergency fund, any debt you pay down in step #2 can be ruined by an unexpected expense.
Baby Step #2 – Pay off all your debts using the debt snowball method
I’m going to be honest with you, step #2 will probably be your longest step. Most of us aren’t going to finish this step in a few months. For most of us, it’s more than likely going to take a few years. This can get frustrating at times, but just remember, in the end it will be all worth it. Our goal is financial freedom, and nothing is going to stop us from achieving our goal.
So here’s how Dave’s baby step #2 works:
First, you take all your debts and put them in order from the least amount to the greatest amount. It will look something like this.
- Credit Card – $1,000
- Car Loan – $8,000
- Student Loan – $15,000
- Mortgage – $100,000
Once you pay all your bills for the month, any extra money left over should be applied to the smallest balance. For our example, this means if you save an extra $100 a month, that money should be put towards paying off your credit card balance. Some of you may be saying, what if I don’t have any extra money each month. Then get some. Get a 2nd job, sell your junk, cut your cable. You have to be willing to do whatever it takes to accomplish your goal.
Once you pay off your smallest debt, you move on to the next smallest debt which in our example would be the car. By paying off the smallest debt quickly you get excited about what you’ve done and you’re ready to get rid of more debt. Once you pay off the 2nd, you move on to the 3rd and so on and so forth, until you’ve paid off all your debt. Pretty simple right?
I have to admit, I don’t fully follow Dave Ramsey’s Debt Snowball method. I skipped paying off a smaller student loan, to put money towards paying off a car. My reasoning behind this is by paying off the car I’d be saving an extra $300 a month, where as if I paid off the student loan I’d just be saving an extra $50 a month. My goal is to free up as much extra money as I can for when my new baby arrives. I could’ve paid off the student loan, then paid off the car, but it would take me an extra 2-3 months. Hopefully, by doing it this way, the car is paid off by the time the baby gets here. Which means, that $300 can now go towards diapers and formula.
Also, mathematically the best method would be to pay off the debt with the highest interest rate first. However, this could end up taking a long time to pay off, which could cause people to give up. This is why Dave Ramsey thinks the debt snowball is the best method. You can get small victories along the way which will continue to encourage you to keep going. For most people, I agree, the debt snowball is the best method. But the important thing isn’t the method you use, the important thing is making a decision to get out of debt and sticking to it.
Baby BStep #3 – Save 3 to 6 months expenses
At this point you should already have at least $1,000 set aside as your emergency fund. This step builds upon that, you’ll be taking your small emergency fund, and turning it into a very large emergency fund. Why, you ask. Because $1,000 is not enough money to cover major emergencies and hard times. This emergency fund will make sure you never have to go into debt again. That means if the economy takes a down turn and you lose your job, you’ll have the money in the bank to keep you going until you find another job. If something happens and you need a major surgery, you’ll be able to pay the hospital bills. Once you’ve gotten out of debt, you want to make sure you never have to go into debt again.
How much you save is really up to you.
I always recommend to save as much as possible, so I’d lean towards the 6 months of expenses. This means if you have $2,000 in expenses a month, you’d need to save $12,000. Seems like a lot of money right? But, you have to remember you no longer have any debt, which means more money you can put towards savings. Imagine how many people wished they had that kind of money in savings when this latest economic downturn happened. And the thing is, many of them could have had that type of money, they just never learned how to save. They never thought about tomorrow, they were only thinking about today.
We always need a plan for tomorrow. We never know what the future may hold. I admit, right now it’s hard for me to be talking about saving 3 – 6 months in expenses. Because all I can think about is how hard its going to be to get out of debt with a baby on the way. I just read, over the course of a child’s life, they will cost $221,000. This scares me to death. But, I’m sticking to the plan. I know it may take a little longer, but I’m going to get out of debt. Now, who’s with me?
Baby Step #4 – Invest 15% of your Income
Investing 15% of your income is Dave Ramsey’s idea of a retirement plan. While it will get you to where you need to go, I’m not sure if everyone will have enough years left to succeed. Let me explain, let’s say you make $50,000 a year. You invest 15% of your income, and after 30 years you’ll have $937,000 if your investments have an 8% return. Sounds pretty good right? The thing is, if you want to retire at 60, you’ll have to start investing 15% at age 30. Perhaps, you’re further along than I am, but I’m not going to be able to invest 15% at age 30. I won’t have all my debts paid off, and I won’t have 3 – 6 months of expenses in savings.
This is why I’d recommend investing as much as you can, as early as you can. If you’re employer has an employee match 401k plan, you’d be crazy not to take advantage. Right now I’m investing 5% of my income, and my employer is matching 4%. Not too bad. My wife has a Roth IRA (whats an IRA?), and she is investing 3%, and her employer matches that 3%. Put all that together, and we’re actually investing 15%. I didn’t even realize that till just now. So maybe we can retire early after all.
Whatever you do, don’t put investing for your retirement off. Compound interest is your best friend, and the earlier you start investing the better. If you can only invest 5% of your income, do it. You’ll be amazed at how much that 5% can add up to after 30 or 40 years.
Baby Step #5 – The Kids College Fund
Our buddy Dave at this point says once we’ve got every thing in our life taken care of, we should start thinking about the kids. The majority of kids these days are going to go to college, and tuition isn’t getting any cheaper. So, he suggests setting up some kind of college fund for the little boogers. His recommendation is an ESA (Education Savings Account), which you can contribute $2,000 a year to tax free. Not too shabby. It might also be worth looking into the 529 college savings plan.
While it would’ve been great if my parents had the money to put me through college, I don’t think parents should have to. It seems that kids are taking longer and longer to grow up, and when we continue to provide for their every need, why would they? I don’t plan on paying for my kids to go to college. Now, before you report me, let me explain. I plan on encouraging my kids to get good grades, so they can get their college paid for through scholarships and grants. If they don’t get good grades, then they’ll be having to borrow from uncle Sam if they want to go to college. It takes the responsibility off me, and places it on them. Also, who’s to say they’ll even want to go to college. There’s plenty of other options out there, that don’t involve a 4 year degree.
The amount of parents who pay for their kids college really surprises me. I’m not saying anything’s wrong with paying for you kids to go to school, if you want to do that. But, I don’t think it should be expected. And I don’t think there’s anything wrong with expecting your children to pay for it themselves. I think this is a choice that should be left up to you.
Baby Step #6 – Early Home Payoff
Dave Ramsey thinks you should stick to a 15 year fixed mortgage, with a payment that is no more than 25% of your income. This seems a bit drastic, but it’s pretty smart if you’re able to do it. I’ve heard people suggest you could have a payment up to 38% of your monthly income, but most suggest somewhere around the 33% mark. At 25% on a 15 year mortgage, you’d have to be making some serious cash in order not to be living in a shack.
I have a 30 year fixed rate mortgage, and the payment is around 23% of my monthly income. I could probably afford a 15 year mortgage, but I don’t feel comfortable putting myself in a situation where if something happens we’d struggle to make the payment. For example, if my wife or I lost our job, we’d struggle to make a larger payment. With a 30 year fixed, we have the flexibility in our budget to make extra payments toward other debts. Or we can save our money throughout the year and make one large payment towards our mortgage principal at the end of the year. Did you know making one extra payment towards principal a year can turn a 30 year mortgage into an 18 year mortgage?
Regardless of how you do it, Dave and I agree you should try to pay your house off early. By paying the house off early you’ll save thousands of dollars in interest. Over the course of most 30 year mortgages, you’ll end up paying more than double what you financed. This means if you finance $100,000, at the end of your mortgage, you’ll probably have paid around $225,000. Kind of makes me sick to think about.
Plus, can you imagine how great it would be to have no house payment. You would know, that no matter what, you’d always have a place to live. It would mean less stress, and more peace of mind. Not to mention the extra money in your pocket, because you’re not sending that big check into the bank each month. This would be a great place to be.
I realize there are arguments against paying off your house early, they’ve been discussed at length on other blogs. But for me, there’s no debate. If you have the chance to get yourself out of debt, you do it. Nothing can replace the freedom you will have once you make that last payment.
So what do we do now?
Baby Step #7 – Build Wealth & Give
Now that we’ve got all of our finances in order, here comes the fun part. We can start giving back. It’s my personal belief that we should be giving back 10% to our local church throughout our journey. But once we get to baby step #7 we can really begin to give, and give big. Some of you may be thinking, why would I want to give away what I’ve worked so hard to get. Here’s the thing God has given us everything we have. We are only stewards of His money. He blesses us, so we can bless others. There’s nothing more rewarding than helping someone in need.
When we get to this point, we don’t need to be selfish. God has put you in this position for a reason. Maybe’s it’s to help some children in your area who can’t afford new school clothes. Or to help a struggling teen mom by buying diapers. Or to help a family who’s having a hard time putting food on the table. The possibilities are endless once you’ve reached this point.
And I’ll go one further. God may not wait till you get all your finances in order before He wants to use you to bless someone. You may be saving that emergency fund when He asks you to help. There’s some of you reading this, that probably already have someone on your heart. Maybe it’s a family at church that you know are struggling right now. If God has put it on your heart that you need to help someone, don’t worry about the emergency fund. You help that person, and God will take care of the emergency fund.
We can have financial plans and goals, but don’t forget who’s in control. No plan can ever take the place of seeking God’s guidance. I hope all of my readers will get to this point one day. That everyone of you will experience financial freedom. But if we don’t make it, just remember God’s in control, and He will always provide for you.
Any thoughts on Dave Ramsey’s Baby Steps?
