I typed up the following overview of Dave Ramsey’s Baby Steps to Financial Peace last year after taking the FPU course. It’s based on an existing expanded baby steps list, some quotes from the DaveRamsey.com site, and some of my favorite related links and resources. If your finances need an overhaul in 2009, check out the steps below and give some thought to giving them a try.
The Expanded Baby Steps to Financial Peace
Both Dave Ramsey’s Financial Peace University course and his Total Money Makeover book are based on the premise of following seven Baby Steps to Financial Peace. These steps are to be completed in order for best results, but inevitably questions like “Where in the Baby Steps should I start saving for a house downpayment?” and “When do I get life insurance?” that are not covered specifically in the original seven steps always come up.
Luckily, the folks over at the MyTotalMoneyMakeover.com forums have come up with a pretty comprehensive list of expanded Baby Steps for us to use. In the unlikely event that your particular situation is not included in these expanded steps, try posting your question in the free Living Like No One Else forum.
So without further ado, let’s take a look at the Expanded Baby Steps!
Baby Steps 0.X: Before You Begin
These are the “pre-Baby Steps” that should be taken care of before you begin the official program. Your chances of success will improve greatly if you can set the stage by making sure you are adequately insured, knowing where you money is coming from and going to every month, getting rid of unnecessary expenses and possessions, and completing as many of these items as possible.
- 0.1 Commit to NEVER borrow money EVER for ANYTHING other than possibly a house.
- 0.2 Talk with spouse and get him/her on the same page as you concerning finances.
- 0.3 Do a written budget.
- 0.4 Temporarily stop all retirement contributions.
- 0.5 Get current on all bills. (You MUST have Shelter, Food, Utilities, Basic clothing)
- 0.6 Get Health insurance NOW (chances of getting sick w/ major medical bills are larger than that of death), especially if you have children.
- 0.7 Get Life insurance NOW if you have considerable debt/your family couldn’t make it financially if you died. Especially important if you have children !! Social Insecurity provides only a small amount of coverage if you have dependents.
- 0.8 Amputate “toys” (bikes, boats, ATV’s etc) if they will keep you from completing the snowball within 12 months
- 0.9 Cut lifestyle (Cut CATV, Cellphone, Regular phone “extra’s”, Internet, Eating out, etc) and/or take second job if $1000 EF will take more than 30-90 days. (depending on income)
Tools & Resources:
- Create a basic zero-based budget online using the Gazelle Budget Lite tool at Daveramsey.com.
- Download and print out the full Cash Flow Planning forms (aka Budgets!) and fill them out by hand
- Try out the Excel*-based Pear Budget spreadsheet attached to this post for another method of budgeting.
- Even more spreadsheets (budgeting, debt snowball, and more) at Jim & Kim’s site.
- Check with Zander Insurance for competitive rate quotes on term life insurance.
- If you are eligible for USAA membership, also check their rates for term life insurance.
Baby Step 1: Save $1000 in a starter emergency fund
This is the first official Baby Step. Dave Ramsey states that most families can come up with this amount in around a month. Save only the $1000 for now (or $500 if your annual household income is under $20,000), then move onto Baby Step 2. The $1000 starter emergency fund (EF) should take care of the most common unexpected expenses like car repairs that would normally send you back into credit card use when you are trying to pay down your debts.
An emergency fund is for those unexpected events that are not regularly planned for happening in life – you lose your job, there’s an unexpected pregnancy, the car’s transmission goes out, or, or, or. Something like this WILL happen. Money magazine says that 78% of us will have a major negative event happen in any given 10-year period of time. So get a rainy-day fund, an umbrella.
This beginning emergency fund will keep life’s little Murphies from turning into new debt while you work off the old debt. If a real emergency happens, you can handle it with your emergency fund.
It’s also the perfect time to get in the great habit of budgeting. John Maxwell says, “A budget is telling your money where to go, instead of wondering where it went.” You don’t have to start a household budget with a perfect month. Start where you are. Write down what you have today. Income and expenses. From then on, spend all your income on paper with purpose before the month begins.
No more borrowing! It’s time to break the cycle of debt!
How do you get this $1000 together?
- Hold a garage sale!
- List smaller, easily-shipped items (tech items do well) on eBay, Amazon, or Half.com.
- List bigger items on your local Craigslist for pick up ONLY, and watch out for scammers!
- Get a second job in the evenings or on the weekends. This isn’t forever–just until you power through Baby Step 2.
- Cut back on non-essential spending.
- Cancel subscriptions to luxury services.
- Visit the IRS Withholding Calculator and see if you have been overpaying your income tax each month. (Hint: If you usually get a big, fat refund every April, chances are you can free up a lot of money by just changing your withholding for the rest of the year.)
Expanded Baby Step 1 Actions:
- 1.1 Chop up your credit cards (CC’s). You have an EF now, no NEED to keep those CC’s !!
- 1.2 Amputate cars that you can’t pay off within 24 months (You have an EF to fix the “bondo buggy” if something should happen.)
- 1.3 Consider raising insurance deductibles to $500 or $1000 and dropping full coverage on paid-for “bondo buggy” (You have an EF ya know!)
Baby Step 2: Pay off debt using Debt Snowball
2.0 Pay off all debt except for the house using Debt Snowball
The math seems to lean more toward paying the highest interest debts first, but what I have learned is that personal finance is 20% head knowledge and 80% behavior. The principle is to stop everything except minimum payments and focus on one thing at a time. Otherwise, nothing gets accomplished because all your effort is diluted.
You need some quick wins in order to stay pumped enough to get out of debt completely. When you start knocking off the easier debts, you will start to see results and you will start to win in debt reduction.
So list your debts in order with the smallest payoff or balance first (excluding the house). Do not be concerned with interest rates or terms unless two debts have similar payoffs, then list the higher interest rate debt first.
Expanded Baby Step 2 Actions:
- 2.1 Start car replacement fund (do not PURCHASE car until step 3 is done or old car dies)
Use the Lloyd’s Debt Snowball spreadsheet to plan your Debt Snowball payments. If you do not have Microsoft Excel installed on your computer, you can download OpenOffice.org for free to view the spreadsheet or use Google Docs online.
Baby Step 3: 3 to 6 months of expenses in savings
Baby Step 3: 3 to 6 months of expenses in savings
Once you’ve paid off all of your debt except for the house, it’s time to pad that $1000 starter emergency fund up to a full three to six months of basic living expenses so you will be truly ready for the bigger emergencies that may crop up: job loss, extended illness or injury, etc.
Having a fully-funded EF will also allow you to reduce the cost of certain types of insurance (esp. car and medical) by increasing your deductibles.
Congrats! Now that you’ve completed the first two Baby Steps, you have momentum! But wait… don’t start throwing all your “extra” money into investments quite yet.
It’s time to build up your full emergency fund.
Ask yourself, “Self, what would it take for you to live for 3 to 6 months if you lost your income?” Your answer to that question is how much you should save.
An emergency is something you had no way of knowing it was coming, something that has a major impact on you and your family if you don’t cover it. A great place to keep this money is in a money market account.
Remember, this stash of money is NOT an investment; it is insurance you’re paying to yourself, a buffer between you and life.
Expanded Baby Step 3 Actions:
- 3.1 Start furniture or other non-essential stuff replacement fund
- 3.2 Move up in car if you still feel the need to (must pay cash for it)
Tools & Resources:
Dave recommends keeping your emergency fund in a money market account or other liquid bank account that pays a decent amount of interest but is NOT an investment account. Here are some reliable online savings accounts and a frequently-updated list of high-yield checking accounts:
Baby Step 4: Invest 15% of household income into Roth IRAs and pre-tax retirement
If you’ve reached this step, you have no payments (but the house) and have saved 3 to 6 months of your living expenses.
It’s finally time to get serious about building wealth.
I don’t suggest investing more than 15% because the extra money will help you complete the next two steps – college savings and paying off your home early.
Well, why not less than 15%? Some people want to invest less or none so they can get a child through school or pay off the home super-fast. I hate to tell you, but the kids’ degrees won’t feed you at retirement, and if you throw all your money into your house, you’ll end up having to sell it to eat and buy the book 72 Ways to Prepare Alpo and Love It. Bad plan.
Expanded Baby Step 4 Actions:
- 4.1 Take your first vacation since finding Dave if you can pay cash for it. (No using the EF !!!)
- 4.2 Save up 20% for home purchase OR pay down existing mortgage to the point you can drop PMI.
Tools & Resources
It’s possible that you already know everything about opening a retirement account and investing in mutual funds, but on the off chance that you need some pointers, here are some excellent starting points:
Baby Step 5: College funding for children
Whether you are saving to go college or you’re saving for your child to go, the important principle is to start NOW! You should have already started Baby Step 4 – investing 15% of your income – before saving for college.
In order to have enough money saved for college, you must aim at something. Your assignment is to determine how much per month you should be saving at 12% interest in order to have enough for college. If you save at 12% and inflation is at 4%, then you are moving ahead of inflation at a net of 8% per year!
NEVER save for college using:
- Savings bonds (only 5-6% growth)
- Zero-coupon bonds. (only 6-8% growth)
- Pre-paid college tuition (only 7% inflation rate)
The best ways to save for college are with Education Savings Account (ESAs) and 529 plans.
Remember, college IS possible without loans!
Tools & Resources
Here are a few quick links to education calculators, general information, and low-cost mutual fund companies offering ESAs and 529 plans:
Baby Step 6: Pay off your house early!
Can you imagine what life would be like if you had absolutely no payments – not even a house payment?!
You’re not too far from making that a reality! You’ve come this far in the Baby Steps; now it’s time to throw all that “extra” money into the largest investment you’ve probably ever made: real estate.
As you attack this last debt, you will gain momentum much like you did back in Baby Step 2 with the Debt Snowball. Remember, having ABSOLUTELY NO PAYMENTS is totally within your reach!
- When selling a home, think like a retailer.
- When buying a home, think like an investor.
- Never get more than a 15-year fixed mortgage.
- Don’t tie up more than 25% of your income in house payments.
Tools & Resources:
Check out the calculators and sites below to help you determine the value of your home and how much can be saved by paying it off early!
Baby Step 7: Build wealth and GIVE!
You can’t shake hands with a clenched fist. – Golda Meir
HOORAY! You are now debt free, house and all! Doesn’t it feel… weird?
“What am I going to do now that all this money isn’t tied up in debt and house payments?” you may be asking yourself.
Build wealth and give like never before. Continue to work toward leaving an inheritance for generations to come. Bless others now with your excess. It’s really the only way to live!
Vow to never have a fistful of dollars held so tightly that those precious dollars never get away. Some people think if they clutch those dollars tightly enough, never giving, they are on the path to wealth. The real world teaches that the opposite is true.
Just try it. Let me know if it doesn’t work.
Tools & Resources:
While many people will choose to give to their religious organization first, those who also wish to give to secular charities might be interested in the following sites which evaluate and/or provide information about legitimate, registered charities or provide you with investment opportunities that will help disadvantaged individuals worldwide via microloans:
- Charity Navigator – Impartial ratings of charities and charity search engine
- GuideStar – Another charity rating site (Free registration required)
- Zopa CDs – Invest in a guaranteed rate CD and help someone out at the same time!
- eBay’s MicroPlace – Your investment dollars fund organizations that make loans to the world’s working poor.
- Kiva.org – Lend directly to a specific entrepreneur in the developing world – empowering them to lift themselves out of poverty.