Dave Ramsey’s most popular creation are his Baby Steps. These seven Baby Steps are feature in Financial Peace University and The Total Money Makeover. The premise is that, by breaking down a large goal (financial freedom), into manageable steps, you are more likely to succeed in achieving your large goal.
Baby Step 1: Save $1,000
The first step to take is to save $1,000 in an emergency fund. You must keep this money for true emergencies. It must be in an account that’s liquid and easy to get too, but don’t make it too easy to take money out. As an add-on to this step, you need to create a budget and make sure you don’t take on any additional debt. Taking on new debt while you’re working on paying down your current debt doesn’t make much sense. This should by far be the easiest and quickest baby step. Later on, you’ll add more to make this a complete emergency fund. For now, $1,000 is sufficient to keep most “emergencies” from derailing your financial plans.
Baby Step 2: Debt Snowball
This step is probably the hardest for most people. And I think that’s interesting, because it comes so early in the process. Once you pass this step though, the rest becomes easy. In this Baby Step you’re going to get rid of all of your debt except your home mortgage. Because the rest of the steps most deal with saving money, they’re much easier to accomplish when you aren’t making payments on your debt. Dave Ramsey is famous for what he calls the Debt Snowball. I’ve covered Dave Ramsey’s Debt Snowball before. In its simplest form, you create a list of all of your debts. Then, order them from lowest balance to highest balance. Pay the minimums on all of your balances, and put any extra income you have toward extra payments on the debt with the smallest debt. Once that one is knocked out, you’re going to have more money to pay on the next debt because you have one less monthly payment. Just keep working your way down the list until you’ve paid them all off.
Baby Step 3: Fully-Funded Emergency Fund
Now that you’re debt-free, it’s time to complete your emergency fund. Dave recommends having three to six months of expenses. If you lose your job, this is going to hold you over so that you can focus on finding a new job rather than being worried about how you’re feeding the family tonight. If you think the risk of losing your job is high, or you’re the single income earner in the household, you should have six months of expenses saved. If you are a dual-income household and your job is relatively safe, three months is probably fine for now.
Baby Step 4: Investing for Retirement
Dave Ramsey recommends saving 15% of your before-tax gross income for retirement. Dave’s strength is in getting out of debt, not investing. So, I wouldn’t put too much weight behind his particular investing advice. Just keep saving the money and invest it in a diversified portfolio of index funds. Make sure to utilize any accounts that can help save you taxes. Roth IRAs and 401(k)s with match are the best. Also, you have Simple IRAs, SEP IRAs, traditional IRAs, and other accounts. If you maximize these accounts and still have money in your 15% to invest, you’ll need to just invest in a taxable investment account. Just try to stay away from short-term gains.
Baby Step 5: Funding College
In this step you save for your children’s college. College costs continue to raise about 2x the inflation rate. A great way to give your kids a head start is to help them get through college with no debt. I think that saving enough for a public education is reasonable, and if your children choose to pursue private education, they can get loans. It’s important they understand the choice they’re making and weigh the costs and benefits of different schools. You should start by saving in a Educational Savings Account (ESA) and then moving on to the 529.
Baby Step 6: Paying off the Mortgage
Very few people ever end up paying off their mortgage, but I think it’s one of the best ways to reduce your personal finance risk. Some will argue that paying off your mortgage doesn’t make sense because then you lose the tax deduction. However, if you’re getting tax deduction, that means you’re paying mortgage interest. I’d rather keep $10k in interest in my pocket than pay that just to get a $3k deduction. Paying $10k to save $3k is a terrible financial plan.
Baby Step 7: Building Wealth
The last Baby Step is to build obscene amounts of wealth. Imagine having absolutely no debt payments each month. If you saved all of the money you currently are paying on your debt, you’d probably be saving a few thousand dollars every month. Imagine how fast that would add up.
If you want to look at the Baby Steps in greater detail, and from the man himself, you should check out Dave Ramsey’s The Total Money Makeover.