Wednesday, February 27, 2008
Live like no one else, so you can live like no one else.
I have been meaning to post about Dave Ramsey's baby steps for a couple of weeks now but I obviously never got around to it. Luckily I found another blog that posted everything I wanted to say but they did a much better job than i would have done. Dave got the baby step idea from the movie What About Bob starring Bill Murray. In the movie Bob plays a mental patient who has several paralyzing phobias who is seeking treatment from a famous psychiatrist, Dr. Leo Marvin. The solution for Bob to get over his paralyzing phobias is to take "baby steps." When getting a hold of our finances, sometimes it helps for us to take baby steps too.
I also preface this whole thing by saying that we never at any time neglect giving back to God. Perhaps I can cover this issue in another post. I say this because the writer emphasizes working really hard to get out of debt so you can enjoy life and be financially free. That is a great position to be in but not at the cost of becoming greedy and not being a cheerful giver like God calls us to be. Okay... hopefully you understand what I am saying. Nuff of me...
Ramsey’s method is not easy. It’s not a get rich quick scheme. It requires sacrifice, hard work, and focus. In fact, printed on the bottom of every page of The Total Money Makeover is the book’s motto:
If you will live like no one else, later you can live like no one else.
Ramsey explains: “If you will make the sacrifices now that most people aren’t willing to make, later on you will be able to live as those folks will never be able to live.” The book is peppered with inspirational testimonials from real people who have taken this philosophy to heart, sacrificing the present for the sake of their future. To me, this is awesome stuff.
At the core of The Total Money Makeover are Ramsey’s seven “baby steps” to financial freedom. By following these in order — and not moving on to the next until the current step is complete — readers gradually progress from debt to wealth. They get rich slowly. Here’s Ramsey’s plan:
Step one: Save $1,000 cash as a starter emergency fund
Before you do anything else, says Ramsey, you must save a $1,000 emergency fund. This money is to be used only for emergencies: car repairs, medical bills, etc. At first I thought I could skip this step. It only took a couple of setbacks for me to realize the wisdom of setting this money aside. If you have a cash cushion, life’s mishaps won’t force you deeper into debt. You’re able to recover more quickly.
Step two: Start the debt snowball
Once you’ve built some savings, it’s time to tackle your debt. You do this with the debt snowball. Here’s how it works:
List your non-mortgage debts from lowest balance to highest balance.
Pay the minimum payment on all debts except the one with the smallest balance.
Throw every penny you can find at the smallest debt.
When that debt is gone, do not alter the monthly amount used to pay debts, but pay all you can toward the debt with the next-lowest balance.
This is the most controversial part of Ramsey’s plan. Critics note that it makes more sense to pay off high-interest debt first. Even Ramsey admits that the debt snowball isn’t mathematically optimal. That’s not what it’s about. “The reason we list smallest to largest is to have some quick wins,” Ramsey writes. It’s about behavior modification over math.
Step three: Finish the emergency fund
Your $1,000 emergency fund was only a start — after you’ve eliminated your non-mortgage debt, it’s time for some serious saving. Ramsey’s advice is fairly standard on this point: accumulate three to six months of living expenses. For most people, that’s $5,000 to $10,000.
The easiest way to do this is to simply take the money you were applying to your debt snowball and convert it into a savings snowball. If you were paying $500 each month toward debt, now throw that money into a high-yield savings account.
(This is the step I’m on now. I have a couple thousand dollars saved. My goal is to set aside $10,000 by the end of 2008. Because I’ll soon be writing full-time, I’m actually hoping to save $20,000, but that may be a bit of a stretch.)
Step four: Invest 15% of your income in retirement
While you’re completing the first three steps (especially the first two), Ramsey recommends suspending all investment activity, even if you have a 401(k) with an employer match. He saves investing for last, once good habits have been established. It’s true that you’ll give up a few years of compound returns in your retirement accounts, but that’s okay in the long run, he says. By following the first three steps, you will have developed smart money habits and a strong saving ethic, so that it won’t take much effort to catch up.
Now that you’ve paid off your debt and saved for emergencies, Ramsey says to invest 15% of your income into mutual funds. He recommends diversifying evenly among several broad categories of funds. Invest anywhere you have an employer match first, and then put money into a Roth IRA. Put the rest of the 15% wherever it makes the most sense.
Step five: Save for college
Once you’ve begun saving for your retirement, you can turn your attention toward your children. Ramsey writes, “Saving for college ensures that a legacy of debt is not handed down your family tree.” Use an Education Savings Account or a 529 plan to save for your children’s college education.
Ramsey also emphasizes that kids can work their way through college in an effort to minimize the loans they need to take out. My favorite piece of advice, however, is to seek scholarships. One of my best friends is a financial aid counselor at a major university. He says that it’s mind-boggling how much scholarship money goes unclaimed every year. The students who know this are able to fund most of their education through scholarships.
Step six: Pay off your home mortgage
Once you’ve taken care of everything else, it’s time for a final, giant step. Ramsey advocates prepaying your mortgage. He’s aware of the objections, but he believes it’s a smart step, anyhow. (For more on this subject, see my recent article on prepaying your mortgage.)
Step seven: Build wealth and give
If you’ve done all these things — eliminated debt, built emergency savings, invested 15% of your income, and paid off your mortgage — you can begin to build some serious wealth, says Ramsey. By following the first few baby steps, you’re far ahead of most Americans. But with the final step, you can enjoy the fruits of your labors. Invest. Give. Have fun. If you want to buy a boat and you’ve completed the “baby steps”, then buy a boat. Just don’t go into debt to do it.