Dave Ramsey's 7 Baby Steps

I recently read a book by Dave Ramsey entitled The Complete Guide to Money. I have to say I enjoyed it and as a consequence I join a number of Dave Ramsey Groups on Facebook. After reading some of the posts in the groups and the comments that they received I came to the conclusion that there is a lot of debates about the effectiveness and correct order in which to carry out the 7 baby steps.

Firstly let’s look at what the 7 Baby Steps are:

Number 1: Save $1,000.

Simple, if not always easy, enough. This first step is a small emergency fund and the first experience of saving for many followers of the 7 steps. A thousand dollars might not sound like much and for some saving this amount may be very easy and quick. Ramsey even suggests reducing this to $500 if your income is below $20,000-a-year.

Number 2: Pay off Debt

Obviously a sensible idea. Ramsey advocates paying off the smallest debts first irrespective of the interest rate on them. This he calls the snowball effect; starting by paying off the smallest or easiest first then building up to paying off the biggest debts. These debts exclude mortgage payments.

Number 3: Create a 3 to 6 month Emergency Fund

This involves saving 3 to 6 months living expenses, not 3 to 6 months of income, as an emergency fund. Once the debts are paid off in step 2 Ramsey thinks that debt should then be avoided at all costs.

Number 4: Invest for Retirement

A fairly late step. In fact Ramsey believes that all retirement savings before reaching step 4 should be put on hold until the financial foundations of steps 1 to 3 are first fulfilled. At this stage putting aside 15% of your income (before employer contributions) is recommended.

Number 5: College Fund

At this stage putting by money towards your kid’s college funding for any savings above the 15% retirement contribution can be made.

Number 6: Pay off Mortgage

As an often cheap debt the mortgage is reserved for late in the process. Ramsey recommends 15 year fixed rate mortgages in order to reduce the time that the debt is a burden.

Number 7: Give

Ramsey is deeply religious and believes in tithing 10% of his income. Even for non religious savers he suggests giving back as an ultimate aim in acquiring wealth and financial freedom.

Resistance

The above may seem pretty sensible and simplified to help people save. The arguing seems to come in with people skipping steps, using credit cards for emergencies instead of building emergency funds and others wanting to begin investing before even starting step 1.

I agree some of the items on the list are not the most financially efficient. For example cancelling your employers matching contributions on a pension in order to build an emergency fund, or paying off low interest debts first just because the outstanding balance is smaller than a debt which has a higher interest rate.

The book is written for people with serious money problems (whether they know it or not) and so it is more important that the steps can be achieved in order of difficulty but still in a timely manner so as to keep momentum and a sense of accomplishment for the saver along the way.

The Psychology of Saving

The first step of saving $1,000 will be a lot quicker if the person is not still contributing to their retirement fund. If it takes the same saver 2 months to complete step 1 without contributing to their retirement account and another saver 6 months I know which saver is more likely to give up before even completing step 1.

With step 2 the sense of accomplishment that comes from paying off a number of small debts first gives the saver the motivation to continue. A saver that has paid off 4 out of 10 debts after 3 months will likely feel a higher level of achievement that a saver that has paid off the same amount but still has 10 debts (albeit with lower balances than before).

There’s a lot of debate about emergency funds in the community. Some argue about the opportunity cost of the savings and the money that could be made by investing instead. Others argue about the number of months needed. I’ve seen some recommend up to 18 months of living expenses.

It seems that the later steps are less controversial. The beginning steps bring in the most criticism. I personally think the psychological gains from building good savings habits far outweigh any financial losses from the method in terms of strict financial efficiency. Unless you have payday loans running at 1000% APR then the inefficiencies in the baby steps, which will probably range from a few hundred to several thousand dollars depending on the savers personal circumstances, should be thought of as a tuition fee on the road to financial independence.