Dave Ramsey’s Baby Steps – Why They Work

Dave Ramsey’s “baby steps” are detailed in his popular book, The Total Money Makeover.  In this article, we’ll take a closer look at each of those steps and see why they work.  There are seven, so let’s dig in!

1. Save $1000

At this point in the game, you’re probably completely fed up with being in debt and spending all your income on monthly debt payments. There is no room in your budget to do much of anything. You’re scared. You’re broke. And you’ve decided to make a change.

Unfortunately, sometimes that’s what it takes in order to make a change. You might not know it right now, but it’s really a blessing in disguise. You’ve reached a crucial point.

This is the point that Dave Ramsey refers to as “being sick and tired of being sick and tired.” This can be a good thing – really!

This is what it takes to make a change and start learning some valuable lessons.  It’s almost transformational because you will likely never make the same mistake(s) again.

I’ve been there.  And the other people who have also been there know exactly what I’m talking about.

It’s time for a change – let’s get started.

The first step of saving $1000 is going to be tough for the simple fact that you have all your money tied up. You have no room in your budget, so you have to make room.

Well, how do you do that?

You do that by cutting your lifestyle down to nothing . . . and then find ways to cut it down again . . . and maybe again and again.

But first,

You have to stop borrowing money.

Just stop. Cut up the credit cards. Do whatever you have to do to stop borrowing money once and for all. If you don’t make a serious commitment to this, then none of this is going to work.

Now, let’s get back to finding ways to save that $1000.

Certainly this is going to look different for different people and their situations, but here are some examples of what I did:

  • Cancelled cable
  • Cancelled my gym membership
  • Stopped eating out
  • Took a lunch everyday to work
  • Bought cheaper food
  • Cooked at home
  • Started cutting my own hair
  • Cancelled all unnecessary monthly bills/subscriptions

The point is to find anyway and every way to free up as much money as you can, while continuing to pay the minimum payments on all debt and pay your necessary living expenses.

You have to get that $1000 saved up as quick as possible (however you possibly can).

The purpose of this $1000 is your “starter emergency fund.”  It’s only to be used for emergencies while trying to get out of debt. The $1000 keeps you out of debt because you will “borrow” from it as opposed to using credit cards.

2. Pay off all debt except the house using the debt snowball

Now that you have $1000 saved and you’re not using debt or credit cards anymore, it’s time to start attacking your debt.  You do this by paying all minimum payments on all your debt.

Time to start gaining some serious momentum, or should I say “snowball” paying off all debt (except for the house – more on that later).

The idea here is to line up all your debts (smallest to largest) and start pecking away at them one by one.

Up to this point you’ve been paying all your minimum payments, you’ve created room in your budget to save up $1000, so the foundation is laid.

Now, with the extra room in your budget, you start throwing all of it towards your smallest debt – while at the same time, continuing to make the minimum payments on everything else.

You do this until you pay off the smallest debt entirely!  Then you take all the money you were paying towards the smallest debt, and chuck it towards the next one.

This is where it starts to “snowball,” growing bigger and bigger as you pay off each debt, allowing you to pay off more and more towards the next debt.  And so on, and so on, until all debt is gone.

3. Save 3-6 months of expenses

Wow, now you are debt free (except the house), congratulations!

Now it’s time to save some serious cash – fast!  This will be your “fully funded emergency fund.”  And it will be easy to do since all debt is finally gone.

Most financial advisers will recommend saving 3-6 months of expenses for emergencies.  That is typical, and Dave Ramsey is no different.  This 3-6 months emergency fund is expenses only.

Your fully funded emergency fund is not, however, the amount that you net in 3-6 months (the amount you net should be a whole lot higher since you’re living below your means and have gotten rid of unnecessary spending).

For most people, this is somewhere around 10 to 15 thousand dollars (maybe more), but this should be the amount that would allow you to get by without an income and still be able to pay all your bills for 3-6 months.

This money is NOT an investment.  It should be stashed somewhere in a money market account or simple savings/checking account (no need to worry about making high amounts of interest on this).  The point here is to have the money as accessible as possible in case of an emergency, hence “emergency fund.”

An example of an emergency would be if your car breaks down, air conditioner/heater goes out, or (God forbid) you lose your job – something like that.

An emergency is NOT:  I think I need those new shoes.  This money should be for emergencies only.

This money is the fully funded version of the initial $1000 saved in step one.  This should be sufficient to keep you from ever having to borrow money again, which is really the point.

Once the fully funded emergency fund is in place, it’s time to start building some serious wealth by investing in retirement.

4. Invest 15% in retirement

At this point, you’ve freed up a lot of money, so steps 4-6 can usually be done at the same time.  Let’s focus on step 4 for now:  saving for retirement.

Most millionaires will tell you (Dave Ramsey included) that you should save/invest 15 percent of your income towards retirement.

Why 15 percent?

I have no idea . . .

This just seems to be about the amount that most millionaires have done. I guess it’s a good number to shoot for in order to build a decent nest egg for retirement.

Most millionaires will also tell you that they built their wealth investing in 401(k)s and IRAs, so that is also what Dave recommends. In fact, he encourages people to do both.

Here’s what I mean . . .

Since most employers will match 401(k)s up to a certain percent, you don’t want to miss out on that.  Dave recommends that you contribute up to at least the company match.  After all, the match is free money!

In addition to that, he recommends contributing to a Roth IRA (you always want to go Roth over Traditional IRA because of the huge amount of tax savings).

Related:  Best Vanguard Funds for Roth IRA

For example, if your employer matches 5 percent in your 401(k), you will want to contribute 5 percent (so you don’t miss out on the company match) and 10 percent towards a Roth.  This will put you at the 15 percent recommendation and will set you up for building some serious wealth.

It is likely the case that you will become a millionaire if you do this.

5. Save for kids’ college

Notice this step is after funding your own retirement.  There’s a very good reason for that: your kids’ college is not going to feed you when you retire.

Also, it’s important to note that this step could also be for your own education, or even someone else’s education, just keep in mind that it comes after making sure your retirement is taken care of.

Generally, Dave Ramsey recommends ESAs (education savings accounts) and 529 plans to save for college.  The reason for this is simple:  these plans work similar to 401(k)s and IRAs for retirement, only they’re for education.

The types of investments for these plans are almost identical to retirement plans – they should be 100 percent invested in good growth stock mutual funds, Dave would say.

That means 100 percent stocks (usually in US equity funds).  The reason for that is because of how these funds have performed historically.

We only want to hold investments that match – or even beat – the S&P 500 (the overall stock market).  If we are investing in those kinds of funds – both for retirement and education – we can anticipate an average rate of return of about 12 percent (because that is what the market has done historically).

For example, if you invest $2000 a year towards college savings in an ESA or 529 (with a 12 percent rate of return), that’s well over $100k in 18 years (plenty enough for any public university).

Don’t believe me?  Check the numbers here.

6. Pay off the house

Now that college is taken care of, it’s time to get rid of that house payment.  Because once that’s gone – wow!  Can you even imagine what life would be like without a mortgage?

You will have so much money coming in (with almost no money going out) you’ll have to end up giving a lot of it away (but that’s step 7, so let’s not get ahead of ourselves).

They say that if you pay only one extra mortgage payment per year, you’ll knock off about 7 years of payments.  Imagine what you could do if you paid two, three, or even six times that amount!  You’d pay off the house in no time.

And if you have no debt, live a modest lifestyle, you’ll have all kinds of available cash to throw towards the house.

A simple mortgage calculator can show you exactly how soon your mortgage could be gone (with whatever amount you choose to pay).

7. Build wealth and give

Once you reach this point, you’ve officially become weird.

You have no debt, no mortgage, and almost no bills. Yet, you still have a full income.  Your retirement is fully funded, and college is paid for.

You’re probably having a tough time deciding what to do with all the extra money you have coming in. That’s called Financial Peace.

When you reach that point, you basically have three options: invest more, spend more, or give more.  If it were me, I’d do all three.  I truly believe that doing all three allows you to have real purpose and worth in this life.

However, you’re free to do differently. 

After all, you’ve earned it.

Why Ramsey’s baby steps work

I think the simple answer to why Ramsey’s baby steps work is because they’re basic. They’re practical.  And anyone can do them.

The steps don’t change; you can’t do one before doing the one prior, and so on and so forth.  It takes all the guess work out of everything.  Each step builds on the previous.

And finally, it will cause you to most likely become a millionaire when you retire – on any amount of income!

About 10 years ago, I reached a point where I was struggling to simply pay my mortgage.  I realized at that point I had no idea what I was doing with money.  I wondered, “How did I get here?”  I made a vow never to let that happen again, and Dave Ramsey’s baby steps have been a helpful guide for me.

When I discovered Dave Ramsey, I immediately started applying his principals.  And slowly but surely, I started to get momentum – I actually started to win with money!

Ramsey’s baby steps have, literally, helped millions of people; I’m just one of those lucky millions.

And if I can do it, so can you.

Conclusion

Once again, you can find Ramsey’s baby steps outlined in The Total Money Makeover, which is a book I would highly recommend by the way.

In short, these steps work because they create a behavior of getting out of debt and staying out of debt.

You cannot spend (or borrow) your way into prosperity. No millionaire will tell you that, and that’s exactly where Ramsey’s steps came from – millionaires.

Most millionaires will tell you that they built their wealth by living below their means, avoiding debt, and investing what they could (about 15 percent of their income), all of which can be achieved by applying these principals.

Anyone can do this if they choose. It’s not a matter of if the principals work or not – of course they do!  It’s a matter of if you’re serious about applying them.