It seems a bit like a rite of passage for every personal finance writer to share their opinion of Dave Ramsey. That alone speaks volumes about Ramsey’s reach in the personal finance sector, but not all of the reviews have been glowing. I personally consider his book, The Total Money Makeover, one of my all-time top three favorite personal finance reads. The book is not overly technical, and is written with an inspirational, “can-do” tone. It is hard to argue with his success in motivating people to finally pay attention to their finances.
Is it time for Ramsey to Update His Plan?
Just last week Jennifer wrote about her issues with Dave Ramsey’s plan in, Falling Off the Dave Ramsey Diet. I have my own issues with some of the numbers, but basically agree with the concept of following “baby steps” towards financial freedom. Here is a look at the original baby steps, as they appear on Dave Ramsey’s website:
1. 1,000 to start an Emergency Fund
2. Pay off all debt using the Debt Snowball
3. 3 to 6 months of expenses in savings
4. Invest 15% of household income into Roth IRAs and pre-tax retirement
5. College funding for children
6. Pay off home early
7. Build wealth and give! Invest in mutual funds and real estate.
It’s hard to argue with the simplicity of Dave Ramsey’s approach, however I have found by tweaking a few of the baby steps, and rearranging them slightly, the plan has worked well for our family. We tried the original baby steps as written several times, but struggled to reach beyond baby step 2. It didn’t take much of an emergency for us to blow through the $1,000 baby emergency fund, and large emergencies still required us to use credit cards to cover. We would restart our savings plan from $0, and kicked ourselves for turning to credit cards again. This also made us hesitant to get rid of credit cards entirely because it was our only safety net against a complete financial meltdown. Here is a look at the approach my family has taken.
The Baby Steps, Frugal Dad Style
1. Cut up all but one credit card. This card should have the highest limit, and lowest interest rate, and should only be used for genuine emergencies. The older the card the better, as keeping your oldest trade line active will improve your FICO score. I recommend removing if from your wallet and stashing it in a sock drawer at home. Do carry the card with you on vacations or extended trips, but again, only use it in an emergency.
2. Six months of expenses in an emergency fund. As I mentioned above, $1,000 just didn’t provide enough safety net for our family. A dead transmission, busted hot water heater, or serious medical emergency could easily wipe out your entire emergency savings, forcing you to turn to credit cards to keep your head above water. This is counterproductive. Instead, we are working to save a full six months of expenses in an emergency fund. Three months may be enough for some families, but since we live on just one income we have little to fall back on. A shaky job market, or general angst over the broader economy may influence the amount you decide to save.
3. Cut up the last (emergency) credit card. With six months of savings in place you are “self-insured” against emergencies and can cut up your last credit card. If you have a credit card with a $10,000 limit, but now have $10,000 in savings, you have essentially replaced the need for an emergency credit card by building your own personal line of credit.
4. Implement the debt snowball. For this step, we follow Dave Ramsey’s plan as written. Pay off debts smallest to largest, regardless of the interest rate. Some will argue this is bad math – higher interest rate cards should go first. Well, we’ve already experienced the momentum Dave Ramsey writes about by paying off several small debts, quickly. These quick wins motivate us to keep going. If you prefer to pay off high-interest cards first, do it. It’s really not worth getting heartburn over. The point is to get busy getting out of debt, one way or another. Get a part time job, snowflake every single amount you can find, have a yard sale, look for “wasted money” in your budget, and make getting out of debt a top priority. Whatever you do, don’t give up! There will be many obstacles in your path to debt freedom, but clearing each one will make it that much sweeter when you reach the finish line.
4a. Invest in your retirement plan up to an employer match. This step should be happening at the same time you are working baby step 4, so I have labeled it step 4a. If your employer offers a match of 401(k) contributions, invest in the minimum percentage to receive that match. Three or four percent of your income isn’t going to make or break your get-out-of-debt plan, and passing up “free” money from your employer just doesn’t make much sense, financially. You’ll also benefit from the added months of compounding growth.
4b. If your employer doesn’t offer a match, skip the 401(k), open a Roth IRA and contribute 3% of your income. The earnings grow tax free! Many people will say it is impossible to save and get out of debt at the same time. True, you divert some financial resources that could be used to pay down debt, but by getting into the habit of saving you are setting yourself up for a much brighter financial future.
5. Max Roth IRA contributions. Now that you are debt free, use the money you were spending to pay off debts to fully fund Roth IRA contributions for you and your spouse. Check the IRS website for maximum contribution amounts and eligibility information. Again, if your employer offers to match 401(k) contributions, continue making the minimum contribution required to get the match. With any amount above that, fund Roth IRAs.
6. Save for kid’s college. With credit card debt behind you, and retirement savings on track, now is the time to focus on saving for your children’s education. Many people, myself included, feel compelled to move this step up in the process because we care so much about our children’s future. However, unless we want to become a burden to our kids in retirement, it is important to get our own finances in order before concentrating on saving for children. We are currently investing gifts and the occasional “found” money in 529 College Saving Plans for both our kids, and will ramp up these contributions when the previous baby steps are complete.
6a. Save for non-educational expenses for kids. In addition to college savings, we have also invested a small amount in single stocks for our kids, allowing them to help in the selection process and in monitoring the stock’s performance. My son now owns a few shares of McDonalds and my daughter owns shares of Disney. Both were purchased with birthday money from relatives. I don’t think they will ever become rich with their investments, but it has sparked an interest in saving and investing. We also set up a sub-account at ING in our names, but labeled for each of our kids, and contribute $50 a month or so for expenses we know are coming down the road: orthodontics, prom dresses, cars, etc.
7. Pay off the mortgage early. Probably the most controversial of Dave Ramsey’s baby steps, this one causes math geeks to go into hysteria! And this hysteria runs even higher in periods of super-low interest rates. Trying to justify to a financial guru paying off a mortgage early at 5.5% versus investing in the market is like trying to pull teeth from a hippopotamus – it just isn’t going to happen! I generally like the idea because one day I hope to “retire” early, and to do that I’ll need to eliminate as many of my monthly expenses as possible. Without a mortgage, it is quite possible for passive income streams to cover our basic expenses, and we could live off a much-reduced salary or income from freelance jobs.
8. Build non-retirement wealth. The problem with only investing inside retirement accounts is that it is nearly impossible to get to your money before age 60. What if I don’t plan on working until age 60? Short of paying penalties, or turning to a 72t distribution (which is based on life expectancy and is nearly impossible to change or stop), there isn’t much choice other than waiting for the magical retirement age to arrive. When we reach this step I plan to invest money above and beyond retirement savings in low-cost, low-turnover index mutual funds such as the Vanguard Total Stock Market Index fund and the Vanguard International Index Fund. Both offer incredibly low expenses, and with low turnover, do not produce high capital gains taxes at the end of the year. It might also make sense to investigate other types of financial products such as low-cost annuities, or bond funds to hedge against fluctuations in the equities market. These funds may then be tapped early to allow for a comfortable lifestyle between an early retirement and the minimum age to access funds from retirement accounts.
I’ll wrap this up by saying that while I am a fan of Dave Ramsey and other financial advisors, no one should blindly follow advice they read in a book, on a blog, or on television (nope, not even on Frugal Dad!). I’ve shared with you what works for our family, but take time to investigate the different options yourself, and implement the best financial plan for you and yours. The great thing about finances is there is rarely only one way to do something, but opinions abound when it comes to money matters so take each one with a grain of salt.