Thursday, May 29, 2008

Madd Money: My Take on the Dave Ramsey "Baby Steps"

Over at another blog that I follow (Frugal Dad, one of my favorite personal finance bloggers), one of the topics he covered this week was Dave Ramsey and his “Baby Steps”. For those who are not familiar with Dave Ramsey, he is a radio and television commentator out of Nashville, Tennessee. He talks about a very common sense approach to money and dealing with debt. In the Dave Ramsey world, debt is full-bore evil and should be avoided at all costs. If you have it, every ounce of energy you have should be applied towards getting rid of it.

What makes Dave interesting and engaging is his charismatic, borderline evangelical zeal for people becoming debt free, and the passion that he invokes in this crusade has garnered him a solid following. Virtually everything that’s relevant to his approach and game plan can be had for free at his web site, along with two weeks worth of his radio show that can be streamed to Windows Media Player or Real Player (his show is three hours each day). For those who enjoy reading the old fashioned way, i.e. pages with a spine and a cover, you can hit up your public library and check out any of his three main books:

Financial Peace, Revisited (this is the “what to do” book, recently updated, and this is the one that basically started Dave's philosophy).

The Total Money Makeover (this is the “how to do it” book, and if you just want to pick up one book to get the feel for the “Dave” experience, this is the one to get).

More than Enough (this is the “why do we care about money in the first place” book, and frankly, it’s his most underrated, and the one I personally most enjoyed. This one actually diverges from standard personal finance and covers a lot of ground that personal development and spiritual development books cover).

OK, right here is were everyone would normally check out and say “OK, dude, Dave Ramsey is great, blah blah blah, you’re a shill, blah blah blah.” Well, I’m hoping I can convince you otherwise, since I think anyone that blindly follows anyone’s plan without giving it serious thought is asking for trouble. What is the Dave Ramsey plan? Here it is in a nutshell, and modified a little bit from his own site:

* Work to get $1,000 to start a “Baby” Emergency Fund
* Pay off all debts (not counting the house, if you have one) using the “Debt Snowball”
* Save 3 to 6 months of living expenses in savings (a fully funded Emergency Fund)
* Invest 15% of household income into Roth IRAs and pre-tax retirement savings
* Save for College funding for children (if you have them)
* Focus on paying off your home mortgage early
* Build wealth and give! Invest in mutual funds and real estate.

If you listen to Dave’s show, he’s pretty dogmatic about these steps, and in general, I agree with what he is suggesting, with some personal caveats and tweaks. Now realize, I am not the best person to ask about how to get out of debt, since I managed to do it with a massive windfall of stock options in both cases; my personal debt was cleared out in 1995 by a massive sell of of stock, we were able to put 75% down on our house because of stock options I owned, and finally, the decision to fully pay off the house came at the expense of my remaining stock options. NOte: I no longer have any, so that puts me on the same playing field going forward as anyone else (truth in writing time, if it weren’t for the fact that I spent ten years working for Cisco Systems in the 1990’s, and had I not been obsessed with the idea of holding onto them, I would have had a very different financial picture).

Dave’s plan is austere, make no mistake, and his mantra is “Live like no one else, so that later, you can live like no one else”. Making Dave’s plan work requires a level of intensity (he refers to it as being “Gazelle Intense”) and *really* making a commitment to pounding through these steps and maximizing them.

1. Work to get $1,000 to start a “Baby” Emergency Fund

This is the first of the Baby Steps, and its purpose is to get you out of the habit of reaching for the plastic whenever an issue happens. Now, to be fair, in most cases, $1,000 will not take care of every emergency, and it will not be the be all and end all of an emergency fund. It’s not meant to be. It’s there as an incentive to say “hey, I just put away $1,000” so that, if I have to deal with something of a medium sized emergency, I have the means to take care of it. My personal approach would be to have a little more than this, but $1,000 as an immediate buffer is still a good number for most people to wrap their head around. This should be in an immediately accessible place, but not *too* accessible. Dave describes one woman who framed 10 $100 bills in a picture frame, with a note that read “in case of emergency, break glass”, and she hung it on the back wall of her closet behind her clothes.

The key to this step is that we need to change our behavior. If we use cash to pay for emergencies, we tend to prioritize in our minds what constitutes an emergency different than when we use plastic. Leg broken and need to visit an urgent care facility, that is an emergency. Big sale on flat screen TV’s, not an emergency.

2. Pay off all debts (not counting the house) using the “Debt Snowball”

This is probably the single piece of advice that Dave is most well known for (not his invention, BTW, but it’s most commonly associated with him anyway). The idea is this, arrange your debts from the smallest to the largest and ignore the interest rates for the time being (if you have two loans with similar balances, then put the one with the higher interest rate earlier in the order). Pay minimum payments on all but the smallest loan value, and with that minimum balance, take every spare penny you can scrape together and pay as large a payment as you can possibly manage every month until it is gone. If you have credit cards, cut them up and cancel the accounts while you do this process. If you can’t bring yourself to do that, at least tuck them away someplace so that you are not tempted to use them. After the smallest account is paid off, roll that same payment you were making before, plus everything else you can muster, on your next debt, and keep the momentum going. Still pay minimums on the other debts that are further down the line, but each debt will get a correspondingly larger amount of money to pay it off. Listening to Dave’s show, this is where you hear some amazing stories, people paying off $30,000 worth of debt or more in a year’s time. How did they do it? It all comes down to behavior and attitude.

You have to really want to do this step for it to work. If you are not pathologically committed to knocking out debt, this will be painful. Hand in hand with this step is the determination to put together a budget, spend every dollar on paper at the beginning of each month (in our family’s case, we do it twice a month) and commit to living by that budget. By doing this, you discover what areas and what frivolous expenses can be eliminated for the time being to attack the debt.
In most cases, I agree wholeheartedly with this approach, but I’d suggest one deviation. If you have a company that pays a dollar for dollar match for retirement savings, by all means take advantage of this, even while you work the debt snowball. Dollar for dollar matches translate to a 100% return on investment. Even the worst loan or debt that you have cannot match that return by paying it off, so take advantage of it if it’s offered to you, but only fund up to the match. From there, throw everything you can into the debt snowball.

Some accountants are certainly going to argue that not putting the highest interest loans first is bad math, but again, I agree with Dave here, this has less to do with math and more to do with behavior and motivation. Cleaning up small debts early in the process gives a psychological boost to the person, and helps fortify them and develop their debt reduction muscles so that they can take on the big ones (such as student loans or HELOC’s) when it is time. Also, if you want to get some motivation, listen to some of Dave's archived Friday shows, where you can hear people scream "I'm Debt Free!" at the top of their lungs. It's an awesome experience, and yes, it's very motivational :).

3. Save 3 to 6 months of living expenses in savings (a fully funded Emergency Fund)

With the debts all cleaned up (minus a mortgage if you have one), the next step is to build a fully funded Emergency fund. The full emergency fund is meant to be anywhere from three to six months of living expenses (note: this is not the same as setting aside three to six months of income, though if that’s an easier way to interpret and set your goal, there’s nothing wrong with that). The $1,000 Baby Fund is just to get you started. It doesn’t take much to wipe that whole thing out (blown transmission, busted water heater, etc). By having six months of expenses saved up, you are in effect “self insuring” yourself against many of the worst case scenarios, and giving yourself the ability to counter those worst cases and ride them out. In our case, we actually have more than six months living expenses set aside (not by a huge margin, but enough to help us weather a serious setback without having to go into debt to take care of it). How much you decide to save is entirely up to you, but remember, this is an emergency fund, and it should be in an account that will bear you a decent return, but not have penalties on withdrawing the money (in other words, Certificates of Deposit or bonds with a time requirement are not good places to put your emergency fund. A high yield savings or money market fund with an istitution like Vanguard or ING Direct, with check writing privileges or a Debit Card, is ideal.. and remember, a vacation to the Bahamas does not constitute an emergency (LOL!).

The biggest benefit to having this is that the need for a credit card becomes almost non-existent. Dave would recommend getting rid of all credit cards and using Debit Cards exclusively. I’m not that hard-core, but I would suggest keeping one high balance card for true dire emergencies (truck crashes into the side of your house or something). Otherwise, use a Debit Card for everyday purchases (or better yet, carry the appropriate cash).

4. Invest 15% of household income into Roth IRAs and pre-tax retirement savings

This is overall good advice, but as I said previously, I’d tweak it a bit. If your employer offers a match in a 401K or alternate type of retirement plan, take it. Dollar for dollar matches are 100% return on investment for those dollars, and you aren’t likely to beat that anywhere else in the same time period without substantial investment risk. Even when you are paying off your debts, make sure to take advantage of this. Once your debts are paid off, then expand beyond the matching limit and contribute and fully fund (if you can) a ROTH IRA. Once you max out the ROTH IRA, then add more money to your company’s 401K (or comparable plan) until you reach 15%. This is an oft quoted number, and I don’t know what makes 15% so magical. Money Magazine back in April of 2007 had an article saying where people should be by certain times in their lives:

Assuming you want to retire at age 60 and plan to have no pension and no job in retirement, you need to have…
1.6 times your salary in savings at age 35
3.5 times your salary in savings at age 40
5.8 times your salary in savings at age 45
8.5 times your salary in savings at age 50
11.9 times your salary in savings at age 55
16.0 times your salary in savings at age 60

I'm comforted to know that, at least currently, we are mostly on track with the figure for age 40 :).

In our case, we contribute 8% towards my company’s 401K plan (their matching is 50% of every dollar up to 3% of my total salary). From there, we push 7% of each check split evenly between our two ROTH IRA’s. Once the ROTH IRA’s get maxed out for the year, then the 7% per check will be adjusted to go back into the company’s 401K plan until the next contribution period begins. We manually handle these transactions right now, but in the future, we will likely automate this process so we can “set it and forget it “ :). Incidentally, for full disclosure, we use Vanguard for our ROTH IRA’s, and currently have an asset allocation of 70% in the Vanguard Total Stock Market Index Fund and a 30% allocation in the Vanguard Total International Stock Index Fund. Why we chose those particular funds would be a philosophical subject for a whole ‘nother post :).

5. Save for kid’s college.

I’m a firm believer in taking care of yourselves and your own financial future regarding retirement before saving for college. While that may sound heartless, let’s face it, an 18-25 year old has a lot more flexibility in working or making arrangements for getting their education compared to a 70 year old facing a retirement without enough savings. Plus, I’d hate to have to be a burden on our kids at a at time in their lives where they have to take care of their own families.

In our house, any money above and beyond the 15% retirement savings that we can save goes towards our kids 529 College Saving Plans (also managed by Vanguard, for those keeping score :) ). In addition to saving for the kids school, we are also actively encouraging them to look and be creative towards scholarship money and grant money where it is available. One thing we have drilled into the kids heads (and our own) is that student loans *will not* be considered unless it is an absolute necessity. Personally, we don’t believe it is, and we will do all we can to cash-flow our kids college educations to the fullest extent we can, and encourage them to work to help get the rest.

5a. Save for non-educational expenses for kids.

There are other expenses beyond college that we are earmarking for the kids as well, and each kid has their own separate savings account that they and we contribute to. These accounts are meant for such things as paying for missions, cars in their future (if relevant), big ticket items that may come along in their lives (prom dresses, summer camp or other special opportunity programs, orthodontics if needed, etc.)

6. Pay off the mortgage early.

For years, I fought this one, and I talked the same line about having a tax write off and investing my money to get a better rate of return elsewhere. Ultimately, I was convinced (and yes, Dave did the convincing (LOL!) ), that there were other ways to look at this. First, would anyone willingly take out a second mortgage on their house so that they could invest that money in the stock market? Some people might say yes, but I’d say “definitely not" because that puts my home at risk in the event I don’t make a wise choice. Well, that’s effectively what I am doing when I pay my mortgage while trying to invest elsewhere. Markets go up and down, but in the long term, they tend to trend up, on average anywhere from 8-12%. My mortgage was 6%. When taxes, gains, and risk are all weighed into the equation, the net benefit of investing tends to become a wash comparing to just owning your home free and clear. As to the idea of a tax write off, let’s just put it this way… would you willingly give someone $10,000, so that the government can give you back $4,000? No matter how you look at it, you still paid $6,000 you’ll never see again. What if you could remove that house payment from your life forever, and then use that original house payment to invest on top of what you are currently investing? That was the argument that ultimately convinced me, and we actually jumped ahead and did this step before we set up the kids college funds. Effectively, our former house payment now covers almost all of our retirement savings, and a good sized chunk of our kids college savings, plus it gives us the greatest feeling of walking through our house and saying “hey, this is *ours*!!!” Seriously, there is no feeling like it in the world.

7. Build wealth and give! Invest in mutual funds and real estate.

So what can you do when you reach this point? This is where people can invest for other things. You may want to set aside money to bankroll a dream globe-trotting vacation, or perhaps start a sideline business, or even get really into giving to causes that matter to you. The key is, at this stage, your income, your investments, and your lack of having to make any debt payments puts you in a totally different category compared to most people that are struggling to make payments. If you can get off the debt payment treadmill, you can use your money to actually do the things you want to do with your life. One of the key points that Dave makes, and I wholeheartedly agree, is that money is really only good for three things once you have met your basic living expenses. It is good for FUN. It is good for INVESTING, and it is good for GIVING. Outside of that, there’s not a whole lot that you can do with money that is long term beneficial or healthy.


Even though I’m a fan of Dave Ramsey, I don’t follow his “gospel” to the absolute letter. I made modifications that made sense to me and my family, but overall his plan is a good one, and a blueprint that many people can use to help make good long term financial decisions. Do not, I repeat *DO NOT* take any financial advice from a blogger or radio personality or author at face value and decide to set up your finances on just that information. BAD IDEA!!! Do your homework, look at your financial situation, and really be critical with yourself. Make a game plan, one that fits your life, your goals and your dream, and then WORK THAT PLAN. Also, realize that any advice I’ve given here is just my opinion and it happens to fall mostly but not totally in line with a guy I like to read and listen to. Consider this a huge case of “Your Mileage May Vary”.

1 comment:

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