The first step of our financial plan is for us to take a look at popular guidelines and plans for fixing finances. We need to test these workflows and determine if they are a good fit for our FIRE journey. There are quite a few out there and some are better than others. Many plans focus on how to spend or not spend your money as you are navigating life.
Today I’m going to focus on the first of two very popular financial plans. Dave Ramsey’s seven baby steps. This is a popular plan taught by Dave Ramsey on his radio show and Financial Peace University. Dave Ramsey has 13 million listeners on his radio program. The program provides guidance based on these principals. Dave has written many books. They include the Total Money Makeover and Financial Peace Revisited.
Dave Ramsey’s Seven Baby Steps
In 2009 and 2010 our household followed the Seven Baby Steps in various levels of enthusiasm. I drank the kool-aid for awhile and listened to Dave’s radio show as a podcast until I couldn’t stand it anymore. There were good reasons that I became burnt out on his radio show, but the lessons stuck with me. They stuck with me because they include sound financial advice. Stay out of debt. Spend less than you make.
Dave Ramsey has built a financial empire around his seven baby steps. He’s written many books, has a radio show, promotes his Financial Peace University. There is much good advice in his work and because of that people pay attention.
Outline of the 7 Baby Steps – Financial Plan
- Save $1,000 in a STARTER emergency fund.
- Pay off all debt using the debt snowball method.
- Save 3 to 6 months of expenses in an emergency fund.
- Invest 15% of your income in to retirement funds.
- Save for your children’s college fund.
- Pay off your home early.
- Build wealth and give.
You work your way from Step 1 to Step 7 in order with very little exception.
This is a workflow which Meriam-Webster defines as:
“the sequence of steps involved in moving from the beginning to the end of a working process”
Baby Step 1 – Save $1,000 in a STARTER emergency fund.
Dave teaches $1,000 is the right amount for most household income’s to use as as an emergency fund as they work Baby Step 2. He’ll often argue a quick approach to savings this amount. A family should be selling things on Ebay.com, cooking beans and rice, and working extra hours to find this cash QUICKLY.
The $1,000 emergency fund is there to cover you in the event of an emergency. Let’s say you are paying off debt and your tire needs replacement. This pays to fix that without throwing off your plan. You then work to build your emergency fund back to $1,000 and keep moving down the plan.
Is $1,000 enough for an emergency?
This is set low to motivate you to work through the next step faster. It’s not enough for our family even for a short amount of time. Currently, we have $3,500 in our checking account and $5,000 in revolving CD’s that is set aside for major emergencies. As we get closer to finalizing our phase I plan we will increase the emergency fund before we tackle our debt payment. This is just the debt on our cars. We’ll target about $15,000 for that emergency fund. Including the money in our checking account and revolving CD’s. Then We’ll increase it from there.
A story of Joe Saver
We’re going to use a hypothetical person named Joe Saver who’s 26 and has built up some debt. Joe mortgages a small house. He lives paycheck-to-paycheck, and he has exactly $1,000 to his name. He can dedicate this cash to the cause of creating a better financial future for himself. He’s going to take that $1,000 and put it in his Baby Step 1 emergency fund and then move on to Baby Step 2.
Baby Step 2 – Pay off all debt using the debt snowball method.
Take your non-mortgage debts and make a list of them from smallest loan balance to largest loan balance. Interest rate IS NOT A FACTOR. Then you will start paying off as much debt as possible on the smallest balance. You do this while making only the Minimum Payments on the larger balances.
Here’s where many people want to crucify the seven baby steps. Because if you look at the math, it will not work out in your favor.
Example of Joe Saver’s Debts:
- $1,500 Credit Card Debt 20% – $20 minimum
- $3,000 Installment loan 0% deferred then 28% – $150 installment
- $4,000 Credit Card Debt 25% – $50 minimum
- $9,000 Student Loan 6% – $100 minimum
- $15,000 Auto Loan 4.5% – $300 payment
Debt Snowball Method
In this scenario Joe’s minimum debt service each month is $620.00. He also has another $180 to throw at his debt each month, so this is what the debt snowball method would look like.
Highest Interest Method – Debt Avalanche
As an alternate option Joe could choose to use the Debt Avalanche. He would then pay towards the balance with the highest interest rate first.
Well that didn’t make that much difference!
It didn’t make a difference in the time it took to remove Joe’s debt. Both scenarios took 45 months. Instead, look at the difference in the total interest paid. Joe paid $354 less paying off his debts using the debt avalanche method. This enlarges with different loan sizes and different interest rates.
Paying the highest interest debt first is always the smart move from a mathematics view.
Then why would I do the debt snowball?
Paying your lowest amount first is going to do two things for you.
You will see faster traction
In the above scenario if will take you until April of 2020 to pay off your first debt with the debt Avalanche. 20 months is a long time to keep making payments without the feel of making a difference. In the debt snowball method you pay off Credit Card 1 in May of 2019. This then frees up the $20 minimum payment you had on that card which brings me to my next point.
You free up cash flow faster
Cash is king. The extra cash flow can make a difference in a small emergency, even $20 in the above scenario. You would have the installment loan taken care of in October of 2019. This frees up $170 per month 6 months before the avalanche method.
Before heading off on either repayment strategy consider this. Put your debts in to the calculator over at undebt.it and see what your payoff and interest time difference is.
Thanks to undebt.it for making it easy to runs these sample calculations.
How is Joe Saver doing?
45 months later and Joe Saver is debt free! He’s now 30 years old. Still single, but he’s recently met someone he’s thinking about marrying.
Baby Step 3 – Save 3 to 6 months of expenses in an emergency fund.
It will depend on where you start this journey. It may take you 5 years or 5 hours to make it to Step 3. This depends on your savings and debt situation coming in to the baby steps. For most, Baby Step 2 can take time. It’s quite rewarding to get to the point of having no non-mortgage debt. Dave Ramsey’s fans often go on his radio show to scream that they are debt free.
Finally debt free, what does Joe Saver do now? He’s had some unfunded liabilities that are now going to take on some of the $800 he freed up in cash flow during Baby Step 2. He needs to put half of it ($400) towards things he hasn’t been spending on. He’ll use it for car replacement and an engagement ring. He still has $400 from old debt money he can spend towards financial betterment.
Also, Joe’s received a promotion where he works (a cushy government job). He now makes $500 more each month he can put towards his financial future. This gives him a total of $900 in free cash flow.
He can start working on his emergency fund which is Baby Step 3. The emergency that he is saving for is a potential job loss, but it may be different when he actually encounters it. Dave Ramsey allows you to make the call how much you save. The amount should be between 3 and 6 months of your expenses. And you should consider your specific financial situation and risk tolerance. Many financial experts will teach emergency funds as large as 12 months.
So how much will Joe save?
Government job or not, Joe is going to save for 6 months of emergencies.
Joe’s expenses are $2,700 a month on a $60,000 a year income. He starts adding to the $1,000 he accumulated in baby Step 1 until he hits $16,200 saved. It will take 17 months to save it in full.
It’s now December of 2023 and he’s saved his emergency fund in full. He’s proposed to and married Mrs. Betty Saver. They had an inexpensive wedding that didn’t cost him any savings. Betty is the same age as Joe, she stays at home and they both live on the single income that Joe brings in.
And it’s time for Baby Step 4.
Baby Step 4: Invest 15% towards your retirement accounts.
Baby Step 4 involves taking your income and ensuring you are savings exactly 15% towards retirement. In Joe and Betty’s case as a single income family of $60,000 they need to save $9,000 total or $750 a month.
Dave Ramsey suggests the 15% is funded from income entirely and is not reduced by any matches given at work. Joe’s in a government job and does not receive a match at work.
Joe does have access to a 403(b) through Vanguard and he begins making contributions through his paycheck which are taken pre-tax. Joe’s marginal tax rate is 12% so the $750 contribution each month only reduces his paycheck $660.
This leaves Joe and Betty free cash flow of $240 each month left for the next Baby Steps.
Baby Step 5: Save for your kid’s college fund
Dave Ramsey often discusses that Baby Steps 4, 5 and 6 are concurrent. When in Baby Step 5 you don’t stop investing for retirement from Baby Step 4.
Baby Step 5 applies if you have kids. Dave Ramsey teaches that future education debt should be completely avoided. You would invest an an ESA (as Dave suggests) or other educational savings vessels such as a 529.
Joe and Betty don’t have kids yet and have no immediate plans to have them. So they move to baby Step 6 with their full $240 cash flow.
Baby Step 6: Pay off your house early
Dave Ramsey teachings include home ownership. He believes that families should own homes.
A few Dave Ramsey home ownership related teachings.
- If you aren’t a homeowner after saving for your emergency fund, Dave suggests a Baby Step 3B. This is where you use your freed up cash flow, before putting it in to retirement, to save a 20% down payment for a mortgage.
- Dave suggests using a longest mortgage length of 15 years. But he also believes that paying cash for your home is the best course of action.
- Dave suggests fixed rate mortgages only.
- Keep your 15 year mortgage and home maintenance expenses to 25% of your take home pay or less. This is likely much less than a standard borrower would be approved for. But it is very sensible advice.
Joe and Betty’s mortgage
Joe and Betty Saver’s current mortgage has an outstanding balance of $80,000 which was refinanced to a 15 year mortgage during Baby Step 3. Their $750 a month mortgage payment ($620 principal and interest, $130 insurance and taxes) fits this equation.
Joe and Betty in 2023 have 14 years left on this mortgage. They take the extra $240 from their cash flow and pay it towards the principal of their mortgage each month.
We will assume that Joe and Betty make no additional money and can’t accelerate the payment further. The additional $240 will move their mortgage repayment from 14 years to 9 years and 2 months. In February of 2033, at the ages of 41, 15 years after they started the baby steps, they have a payed for house.
Baby Step 7: Build Wealth and Give
Dave teaches his last step as a “what-to-do” once you’ve completed the previous 6 steps. You have paid off all debt. You have healthy emergency savings. You are funding future liabilities and have a paid for house. You’ve freed up your principal ,interest and extra principal payment on your mortgage. What do you do then?
You do two things. Invest more and Donate more to charity.
Dave has suggested making charity part of your spending plan. He suggests giving 10% based on the biblical teaching of the tithe. This is not something we do in our household spending. But Dave suggests not stopping at 10% and this is the point you would donate more.
And also you add to your investment savings. Fund your retirement accounts further if you haven’t already hit the maximum in Baby Step 4. Fund taxable investment accounts.
Back to Joe
Joe and Betty in the 10 years they have been saving for retirement have accumulated $153,127. This assumes they were invested in low cost S&P index funds and that the average gain met the last 90 year 9.8% S&P average return.
These numbers aren’t quite FIRE level numbers. But at 41, Joe and Betty Saver come very close to the rule of thumb to have 3x your annual salary saved.
Let’s assume they took $500 of their cash flow freed up from paying off the house and added that to the $750 per month they were already investing. In 14 more years at the ages of 55 they would hit their Financial Independence number of $1,050,000 saved. This assumes 25x annual expenses of $3,500 per month.
Consider that they may not be ready to retire at the age of 55. If they push retirement to 62, they would have 2.2 Million saved. This would allow them to draw $7,000 a month. They wouldn’t need to worry the nest egg would run dry. This is beside payments from social security and government pension funds. The Saver family would be set for retirement.
A conclusion from the Seven Baby Steps.
The workflow works as a financial plan. And it works relatively well.
It may not make the most sense at times from a mathematics stand point, however it does take care of the basics needed in a financial plan.
- Provides a way to eliminate debt. CHECK
- Provides a guideline to reduce spending and increase cash flow. CHECK
- Prepares for emergencies. CHECK
- Limits Risk. CHECK
- Prepares for the future. CHECK
Are the Seven Baby Steps a sound plan for FIRE?
It’s not a workflow that creates a financial plan for FIRE.
The focus on paying down your mortgage before investing zaps potential returns and increases the time it takes to hit your FIRE number.
Some could also argue that using a 15 year mortgage in lieu of a 30 year mortgage accomplishes the same thing. You are reducing the opportunity value of your money by tying it up in a large payment where money can be loaned for cheap.