Dave Ramsey’s Baby Steps Part 1: Understanding The Steps

Are you a Dave Ramsey fan?

When I was first getting out of debt, I started with Dave Ramsey. I’ve said before that I’m not wild about everything Dave preaches, but I do think he’s great at understanding the mindset of people in debt. More importantly, he understands the motivation people need to get out of debt.

He is known for a lot of things, but possibly the most famous is his Baby Steps. The Baby Steps are often called a plan for getting out of debt, but that’s actually only part of the process. The Baby Steps are actually a pathway to what Dave calls Financial Peace.

What is Financial Peace? Well, surprisingly, I wasn’t able to find Dave’s definition. I can tell you his goals of Financial Peace – strengthened relationships, sense of hope and freedom, ability to create a legacy, and freedom to give generously. But I couldn’t find an actual definition. So I’m going to make one up!

Financial Peace is having enough control over your money (including saving, spending, and investing) that you can live debt free, be financially successful (not necessarily rich), and prioritize your financial decisions based on your values, not requirements.

I’ve spent a lot of time thinking about the Baby Steps. Besides the time it took me to get out of debt, I also was a Financial Peace University coordinator several times. I’ve also read Dave’s book Total Money Makeover – that’s what introduced me to his process in college. For a while, I thought the Baby Steps made perfect sense.

But you get older and wiser, and sometimes the things that seem like a great idea at one point in your life seem less great later on. Luckily I’m not talking about anything too ridiculous here. I’m talking about the Baby Steps.

Introduction to the Baby Steps

The Baby Steps are straight forward. They aren’t always easy to accomplish, but they are simple to understand.

Baby Step 1: $1,000 cash in a beginner emergency fund
Baby Step 2: Use the debt snowball to pay off all your debt but the house
Baby Step 3: A fully funded emergency fund of 3 to 6 months of expenses
Baby Step 4: Invest 15% of your household income into retirement
Baby Step 5: Start saving for college
Baby Step 6: Pay off your home early
Baby Step 7: Build wealth and give generously

Okay…well maybe they need a little explanation.

One thing before I explain the steps in a little more detail – they don’t all have to be accomplished, but they do have to be accomplished in order. At least, that’s Dave’s theory.

What that means is if you already have an emergency fund, you could skip right to Baby Step 2. And if you don’t have kids, you would skip Baby Step 5. But if you were in Baby Step 6 or 7 and then had kids, you would stop those and go back to Baby Step 5. Get it? Cool.

Baby Step 1: $1,000 cash in a beginner emergency fund

This is basically exactly what it says. Put $1000 in an emergency fund. Focus all efforts on that until complete. A lot of people push back on this one because they think it’s not enough…we’ll get to that in Part 2. If you happen to have a low income – which Dave defines at $20,000 or less each year – then he says you are okay with $500. And if you are going to be in debt a long, long time, he says you can raise it up to $2000-$3000.

Baby Step 2: Use the debt snowball to pay off all your debt but the house

This one is more complicated, and it will be a big part of part 2.

The simple explanation of the debt snowball is that you write down all of your debts other than a mortgage (if you have one) in order from smallest to largest. That’s the order you pay them off. You don’t pay them off by which one is due to end soonest. You also don’t consider the interest rate, unless you have multiple debts with the same total. In that case you pay off the one with the higher interest rate first.

Baby Step 2 is all about psychology. It has you pay off debts from smallest to largest because you get quick and easy “wins” of paying something off. If you have one loan of $200 and another of $2000, you can pay off the $200 loan sooner and get the adrenaline rush of that victory. Or dopamine. Or serotonin. I don’t know. Whatever chemical gets released in your body when you have a win.

The “snowball” part of the debt snowball is what is happening with your money as you pay off the debts. You pay only the minimum payment each month to everything except the debt with the smallest balance. When you pay off your first debt, you take the money you were putting towards that and add it to the minimum payment you were paying on the second smallest debt. When you are done paying that off, you add it to the minimum payment of the third smallest debt. So on and so forth.

It’s like a snowball rolling downhill. It’s constantly adding more snow to the outside and getting bigger and bigger until it just demolishes your debt.

Baby Step 3: A fully funded emergency fund of 3 to 6 months of expenses

Once all of your non-mortgage debt is paid off, you move into building up an emergency fund of 3-6 months’ worth of expenses. Not income – expenses. This is meant to keep you from incurring new debt in the future.

Not much to say here, at least not in a simple overview. It’s pretty self-explanatory.

Baby Step 4: Invest 15% of your household income into retirement

Finally – in Baby Step 4, people going through the Baby Steps can start saving for retirement. Dave wants people to put 15% of gross household income (not net) into retirement accounts. His plan has the money going first into workplace retirement accounts (401(k), TSP, 403(b), etc) that receive matching, then into Roth IRAs.

As you’ll guess, I’m going to have some stuff to say about this when I write part 2 of this post. Timing, amount, account type…there’s a lot to address.

Baby Step 5: Start saving for college

This Baby Step is to start putting money away for your children’s college expenses. Dave recommends using 529 plans and Coverdell Education Savings Accounts (ESAs). Those are tax-advantaged accounts, just like 401(k)s and IRAs, but specifically used for educational expenses.

Again, I’m going to talk more about those recommendations in part 2…they are fine for some, but not all, circumstances.

Note that college savings comes after retirement savings. There are scholarships and loans for college. None of that exists for retirement, so retirement savings comes first. On this point I agree wholeheartedly with Dave! I don’t care how much you want to help your kids. Trust me, when you are moving into their house at age 70 because you didn’t appropriately plan for retirement, they’ll wish you’d prioritized retirement savings.

Baby Step 6: Pay off your home early

In this Baby Step, you finally attack your remaining debt – if you have it. The mortgage. This one is as straight forward as they come. Pay off the mortgage early. If you have a non-standard, more risky mortgage (interest-only, adjustable rate, etc) Dave recommends trying to refinance into a 15-year fixed. He even recommends that for a 30-year conventional loan…Dave likes 15-year mortgages!

Baby Step 7: Build wealth and give generously

This is what Dave calls your time to “Live and give like no one else.” Your debts are paid, you are saving for retirement and your kid’s college, and since you paid off the house you probably have some money to spare. This is when Dave says you can max out your retirement accounts. Or maybe you increase the college savings (I’d start with maxing out retirement). Maybe it’s time to start saving for your next house so you can be sure to put down 20% or more and hopefully afford a 15-year mortgage.

It’s also when you can start giving money to help others, above and beyond a tithe or other normal charitable contributions that you may have already been giving. Since you’ve taken care of your own financial life, you can afford to give generously. Nice, right?

Why I’d Change Dave’s Baby Steps

While Dave’s plan is great for a lot of people, it’s not perfect. It isn’t the best from a math perspective, for one. And it’s very “one-size-fits-all” which doesn’t make a lot of sense when you are talking about personal finance.

One thing I’ve noticed over and over and over again is that people find it difficult to follow Dave’s steps exactly as written. And make no mistake – he thinks you need to follow them exactly as written! And if you dare suggest anything different in a Dave Ramsey group, watch out! You’ll quickly find yourself either censored or even removed!

Because I don’t agree 100% with the Baby Steps, in part 2 I’m going to talk about what I’d change if I were creating a world-renowned path to financial freedom. I’m never going to be as famous and far-reaching as Dave, but maybe it will help some of you!

Have any of you used the Baby Steps? Did you follow them exactly as written, or did you change things up a bit?