Since the 90's The Dave Ramsey Baby Steps have been synonymous with personal finance for middle-class America. I’ve listened to many podcasts and I've read many blogs, and Dave Ramsey's name stands out to me above most others.
Brad and I are a 6th or 7th generation media personalities. I don’t want to say that we are a dime a dozen, but there are a-lot more of us to choose from. But Dave was one of these first-generation personal finance coaches. Nobody was doing this back in the 90's. He had a million-dollar real estate portfolio and he crashed hard into bankruptcy. He pivoted and started with a radio show helping people avoid his mistakes. Around the same time, he created a small book called Financial Peace and started offering it as a free resource to his church. The radio show gave him a platform to sell the book and the Dave Ramsey Baby Steps nationwide and he turned it into a multimillion-dollar dynasty.
He based everything around seven baby steps and built a tribe of debt-free warriors. His product went viral in an era that predated social media and blogging.
I think everybody would benefit from listening to him and I would not be here today doing this blog and podcast if it were not for Dave. I owe him a debt of gratitude!
So now, more than 15 years later, we wanted to review and evaluate Dave’s teaching philosophies. We wanted to see where we line up and where we go our separate ways.
At ChooseFI we subscribe to the “FI” (Financial Independence) way of thinking. Which broken down to it's simplest explanation is to keep your expenses as low as possible, invest as much as you can in low cost, broad-based index funds, and when you have saved 25 times your annual expenses you are considered financially independent. What you do at this point is up to you. Many people quit their day jobs to start businesses or reduce their hours to part-time. Others stop working entirely and travel, pursue hobbies, or just spend more time with their families. The point is, when you can live off your investments, your time is your own.
Baby Step 1: Get an Emergency Fund of $1,000
Dave says that this is to prevent Murphy from knocking on your door. You know the saying:
What can go wrong will go wrong.
I think this is a universal Truth. Accidents tend to happen when you can least afford it. I don't take the small stuff for granted. But I know people that don’t have a checking account and I know people that have been forced to take out a payday loan for an emergency. A payday loan will typically be a short-term loan for $600-$1,200 dollars. And the interest usually runs $200-400 per month
$1,000 can be enough to stave off financial disaster. So, as Dave says:
Keep your grubby hands off it…. Don't touch it. It's not so you can get your nails done, it's for an emergency.
Baby Step 2: Pay off all debt Except your Mortgage
In this step, Dave recommends using a debt snowball, which involves paying the smallest debt down first. Here are his steps:
- Make a list of all your debts.
- Rank the list in order from largest to smallest.
- Make the minimum payment on all debts.
- Throw every spare penny into the smallest debt.
- When you have paid off the smallest debt, then throw every spare penny into making extra payments on your second-smallest debt (which is now your smallest debt).
- Repeat until finished.
But, Mathematicians often favor the debt avalanche
This goes as such:
- Make a list of all your debts.
- Rank the list in order from highest-interest to lowest-interest.
- Make the minimum payment on all debts.
- Throw every spare penny into making extra payments on the highest-interest debt.
- When you have paid off the debt with the highest interest rate then throw every spare penny into making extra payments on your second-highest-interest debt (which is now your highest-interest debt).
- Repeat until finished.
I favor a hybrid
Try to tackle the smaller ones first. Group all debts below $1,000 together. As long as the interest rates are similar then use the debt snowball and pay off the smallest debt first.
Exception: If you have any payday loans with 200% interest rates pay those off first.
Group the remaining debt by interest rate and pay off your any debt that has over a 6% interest rate specifically let's get rid of consumer debt like credit cards anything that's making your life more expensive let's get rid of your car payments.
My two cents for step 2
I have noticed that Dave really doesn't try to give you many actionable tips to help to decrease the cost of your life–which can help you reduce debt.
The entirety of his decreasing expenses plan can be summed up as:
- Have a yard sale
- Sell your car
- Work a second job (deliver pizzas)
This may have been enough advice back in the 90’s but I think it's a shame that he doesn’t go any deeper on how to actually decrease expenses. I think we can do better.
- What if you could cut your food bill in half? I’ve been writing an article series called the Ultimate Costco Meal Plan where you can serve a family of four for around $300 per month.
- Slash the cable and cell phone bill.
- Slash the electric bill.
- Become the CFO of your own life. Become a hawk looking at every recurring expense.
- Check your life insurance premium
- Get a fresh quote on your Auto insurance
- Refinance your student loans to capture a lower interest rate
Other points of contention in step 2
Dave Ramsey tells you to hold off on the match with your 401K while you're paying off debt. I can’t recommend this. I have no problem with not maxing out your 401K, but we don’t walk away from free money. You always do the match.
He makes the case that you're being chased by the cheetah and it's short-term, usually less than two years. Maybe for some very specific situations where someone is close to the edge, like a payday lending situation, this would be good advice. But I think the audience is important. He is focusing on people dangerously close to the edge. You can’t apply that to everyone! If you have some debt at 5% you don’t pass up doubling your money (100%) to pay down 5%. That's dumb math! My wife and I have always taken advantage of match programs and we have some significant savings based on that alone.
Baby Step 3: Get 3 to 6 Months of Expenses in Savings
I agree with the importance of an emergency fund and savings but I have started to question the best place to keep the emergency fund. Especially for someone who is saving 20-60% of their income. Does this need to be in a basic savings account earning zero interest? I think it's so important to get your money working for you. We explored this in an episode with Big ERN. Don't misunderstand, I think it's incredibly important to be able to weather a financial storm and have a clear plan in place, but to be honest I skipped this step and went right to investing.
I have insurance.
Insurance is a backstop; if I have a death in the family, or my house burns down, or the car breaks down. I have to cover the max out of pocket but after that, I am in the clear.
What if I lose my job?
This is where the personal factors come in and you have to weigh in how secure is your job? What would you do if you lost your job?
But it's important to play this out
Can you get another job?
Note that since this is an emergency you don't need to replace your income just cover your expenses, the lower your expenses are the smaller your cash emergency fund needs to be.
Do you have another source of income?
Side hustles are great for many reasons, one of which it can serve to cover some expenses if you lose your main source of income. Depending on the side hustle you may even be able to ratchet up the income and cover most if not all of your basic living expenses while you look for a new job.
What if I have an expensive emergency?
If I had an unexpected $10,000 emergency:
- I have a decent amount of money in my taxable accounts (for me it's Vanguard VTSAX) I could access within a week
- I have a credit limit on multiple cards approaching $30,000 with a 30-day interest-free float
- I could set up a HELOC ( Home Equity Line of Credit)
- I can access Roth Contributions and have nearly $10,000 in those accounts (contributions can be accessed tax and penalty free)
- I could sell something
- I could cash flow it (because my savings rate is so high) I can cut back on my savings and focus on paying for the expense.
Obviously, this is incredibly situational, and I don't think the emergency fund is a one size fits all answer. But too often it is taken as dogma. I guess more accurately I think everyone should have savings and the ability to financially survive emergencies I just question whether that massive emergency fund in the checking account is necessary for everyone.
Investment life hack
I also like the idea of using a Roth IRA for an emergency fund because you can park it in VTSAX and you can withdraw contributions without penalty at any time. So, between those categories, you should be able to access 3 to 6 months of expenses. Keep in mind that withdrawing from your Roth will mean you can't max out your contributions for that year. The money you withdraw doesn't subtract from the money you contributed. For example, If you contribute the max of $6,000 and then in November you withdraw $1,000, you can't just put that $1,000 back in December. You've already contributed the full $6,000.
Baby Step 4: Invest 15% of Household Income into Roth IRAs and Pre-tax Retirement
Dave Ramsey commonly assumes a 12 to 18% rate of return. To justify that, he recommends that you use his endorsed local providers who are active fund managers.
In most of the math equations that he uses, he assumes that 12 to 18% rate of return. He has been criticized by most fact checkers for continuing to use these numbers to make projections. But we do not have the time to dive into whether or not this is possible. We try to use more realistic numbers like an 8% average rate of return which should provide more realistic results.
Okay so let's look at the reality of Dave's plan by using two case studies. Let's say that our individual invests 15% of their household income into a Roth IRA and pre-tax retirement:
Tom makes $40,000 a year and invest 15% or $6,000 annually and does a combination of pre-tax and post-tax investment accounts. He does this every year for his working career, which is 40 years so from the age of 20 to 60. He never gets a raise, which is unlikely, and he never fails to contribute. He’s going to have 1.6 million dollars.
Amy decides to go to grad school. This is a 12-year path including four years of undergrad (age 18 to 22), four years grad school (age 22 to 26), and finally, four or five years pay down her loans (age 26 to 30). Amy earns a higher salary of $100,000 per year. But, because of school and student loans, Amy was not able to start investing until she was 30. Amy only plans on working/investing for 30 years till the age of 60. She invests 15% or $1,250 a month. At the end of 30 years, Amy would have $1.8 million dollars.
Tom and Amy both retire at age 60 with roughly the same amount of income in retirement.
But here at ChooseFI, we are not interested in a 40-year career. We plan on putting a lot of work in now so it becomes optional in the future.
But for most Americans, even saving 15% sounds extreme. The average American saves less than 5% of their income.
However, in the FIRE community, 30%, 40%, and even 70% savings rates are not uncommon because we understand the simple math of early retirement. More specifically, we understand the importance of your savings rate. We live far beneath our means, focusing on building passive income streams through investments, real estate, and business ventures.
Joshua Sheets from Radical Personal Finance had a podcast episode where he aptly pointed out if you want to experience Dave’s level of success. Don’t do what he says–do what he did:
What did Dave do?
- He slashed his cost of living creating space between is cost of living and income
- He built a business from the ground up
- He scaled it to reach millions
That's what we are doing here now and you can be a part of that.
Baby Step 5: College Funding for Children
We all know that student loan debt is astronomical. The only answer to that is: teach your children about saving for college. This step no one disagrees with.
But college has changed a lot in the 15 years since Dave Ramsey came out with his baby steps. Now you have to do a lot more planning.
For even more ideas, here's what our friend, Justin of Root of Good has to say.
Baby Step 6: Pay Off Your Home Early
This one we agree with–maybe.
What’s your interest rate and what’s the alternative? Do you have a 3% interest rate? Before 2018 I would have said that this could be a large contributor to what allows you to itemize. In 2018 the standard deduction for a married couple went up to $24,000! Let's be realistic very few people in the middle class are itemizing anymore. So 2018 has tipped the scales towards paying it off
Let's look at a couple of reasons to not pay it off
What's the opportunity cost of paying off your mortgage?
If the stock market earns an average of 8% per year and the interest rate on your mortgage is 3% then you are forfeiting 5% by paying off your mortgage.
You could have made this money by investing that in the stock market.
Sequence of Return Risk
Have you considered sequence of return risk? This concept was first explained to me by Big ERN over at Early Retirement Now. It basically says that the returns of the market over the first five years after you invest will have an outsized impact on whether your savings and investments will run out or not. You can minimize sequence of return risk by investing over long periods because you have bought at so many different price points you have a more stable fund. If you spend your entire working years paying off your home and delaying investing until you do, this can increase your susceptibility to a market downturn. The couple that delays investing until there home is paid off and doesn't start investing until late 40's early 50's could find them self at high risk of sequence of return risk. Whereas the 30-year old that finishes paying off their home by 35 likely still has time to build significant wealth is at less risk.
You Can't Downplay Flexibility & Freedom
I go back and forth on this one and clearly don't have the perfect answer. Mathematically it's probably suboptimal but the freedom and flexibility that not having a mortgage provides should not be discounted. I would never tell someone that they made a mistake by paying it off. It “may” be a mathematical mistake but that doesn't mean it's a life mistake.
Baby Step 7: Build Wealth and Give!
This is literally the conclusion of Dave Ramsey's book. This sounds so boring. I would like some sizzle. I don't mean the pyramid scheme sizzle, which dazzles with free cars and a personal island in the Bahamas, but why go through the fire if not for some reward?
I think the reward is freedom and flexibility. You get to design your best life now and maybe that's not opulence, but service and family time. Or maybe it's traveling the world and consulting on ideas that you love to think about. Maybe it's writing a book as you geo-arbitrage around the world. So many options and the only thing you are running out of is time!
This allows for extreme flexibility.
Explore Travel Rewards, which involves taking advantage of credit card sign up bonuses to earn 5-10K in free travel each year. Become an expert at putting these travel hacks together. Then use the flexibility of FI to have the time to take advantage of four-week vacations anywhere in the world with my family.
If you want to listen to the podcast that went along with this episode, click the link below: