When it comes to financial planning, one of the most well-known frameworks is Dave Ramsey’s Baby Steps.
What makes the framework so popular is its simplicity. You just work through the steps in order, making sure to check off each of the seven before moving on to the next one.
But the big question is this: should you follow the Baby Steps formula or is there a better path to pursue?
This article will:
- Review each of Ramsey’s seven Baby Steps.
- Look at the pros and cons of each Step.
- Outline the plan I would follow instead of Ramsey’s.
Overview: The 7 Baby Steps
Dave Ramsey’s seven Baby Steps are:
- Baby Step #1: Save $1,000 for your starter emergency fund.
- Baby Step #2: Pay off all debt (except your mortgage, if you have one) using the debt snowball method.
- Baby Step #3: Save three to six months of living expenses in a fully funded emergency fund.
- Baby Step #4: Invest 15% of your household income in a retirement account.
- Baby Step #5: Save for your children’s college fund.
- Baby Step #6: Pay off your mortgage early.
- Baby Step #7: Build wealth and give.
Baby Step #1: Save $1,000 to Start an Emergency Fund
Summary: Ramsey suggests building a $1,000 starter emergency fund before investing or starting to pay off high-interest debt.
Does it make sense? Yes and yes! Having a small amount of cash savings is vital.
In fact, the Federal Reserve did some research on families with low incomes who had a $500 emergency fund in place. What they found was that when a financial hardship occurred, these lower-income families fared better than middle-income families who did not have $500 set aside.
Tips for success:
- The goal is to accomplish this step as quickly as possible.
- Give yourself a deadline. Design a plan that can help you save $1,000 as fast as possible — ideally, in 30 days or less. This may involve some creative strategies, and you may miss the mark. That’s OK, as you’ll at least be better off than you were a month ago.
Baby Step #2: Pay Off All Debt (Except Your Mortgage) Using the Debt Snowball Method
Summary: When paying off debt using the debt snowball method, you start with the lowest balance first. For example, if you have two credit cards, you focus on paying off the one you owe less on first, even if the interest rate on that card is the lower of the two.
The idea behind this strategy is that paying off the lowest balance first is a more achievable goal, and that doing so will help you build momentum.
Does it make sense? As a CFP® with a love of numbers, it may surprise you to learn that I’m a big fan of the debt snowball strategy. In fact, studies have proven that more people succeed in paying off their debt with the debt snowball.
Editor’s note: The alternative to a debt snowball is a debt avalanche, where you pay off your debts in order from highest interest rate to lowest.
While I love the debt snowball method as a strategy for paying off debt, where I disagree with Ramsey is that he recommends using it to pay off all debts beside your house.
First things first: if you have high-interest credit card debt — which we’ll define as being around 18% APR — you want to focus on getting rid of that debt ASAP. You can’t get ahead when you’re paying that much interest.
But what about things like student loan debt, which often has an annual rate of around 6%?
For lower-interest personal debts like those, a good number to keep in mind is 7%. That’s the average percentage that the stock market returns (after inflation) each year.
So, if you want to go by the numbers, it makes sense to pay off any debts above 7%, while prioritizing investing over paying down those with rates of less than 7%.
Think about it like this: if you can make 7% by investing, you’re losing money by paying off debt that costs less than 7%.
Important notes: The exact equation is more complicated than this. For example, you may lose a deduction for paying off your student loan debt early, or get a deduction for starting to invest.
Plus, it’s worth mentioning that paying off debt is a guaranteed rate of return, while investing does not offer such guarantee. So look at 7% as a rough guideline, not an absolute law. Often, it comes down to what you’re more motivated to do.
Another situation worth mentioning here is when your employer matches your 401(k) contributions. In that case, you’re getting as high as a 50% return on your money. I would absolutely invest up to the maximum at that rate of return prior to paying off my lower-interest debts, because choosing not to is the same as walking away from free money.
Tips for success:
- Behavior can trump math. A study published in the Journal of Consumer Research — which is summarized in plain language in this Harvard Business Review article — found that it’s best to pay off your smallest debt first, even though this doesn’t save the most money in the long run.
- Know your debt payoff date. Use The Ways To Wealth’s debt payoff calculator (instructions can be found in our how to pay off debt article) to identify the amount of time it would take you to become debt free.
Baby Step #3: Save Three to Six Months of Expenses
Summary: In Baby Step #1, you built a beginner emergency fund, setting aside enough money to prevent a sudden financial setback — like an unexpected car repair — from spiraling out of control. But you also need to think about whether your finances can withstand a more prolonged setback, such as losing your job.
Does it make sense? I have a few thoughts about this particular Baby Step.
- Six months is a lot of money for beginners to set aside, and it may be more than you actually need. Analyze your situation and your risk, and make sure you’re taking everything into consideration.
- For most people, the biggest risk is losing a job. So it’s important to analyze just how big a risk that represents in your particular situation. Are you in a field where you can easily replace your job if your company announces layoffs, or would you have trouble replacing your current level of income? If you have low risk, you may be able to get by with just three months of expenses tucked away.
- Building an emergency fund and investing don’t have to be mutually exclusive. It’s possible to do both. If you have a 401(k) match, I would contribute up to that match and build your emergency fund at the same time.
Tips for success:
- Make it a challenge. Try to do it fast, because that speed will help you avoid giving up. Set a goal and make it aggressive.
- Take up a side hustle that has big potential. You can make a lot of progress in a few months with these side hustles. This is one of the single best ways to make headway on this baby step, as it’s often easier than trying to cut your living expenses.
- Look for a higher paying job. If a side hustle won’t work, don’t be hesitant to switch companies. You can often command 10% to 20% more in salary just by changing employers, and that will mean a lot more money going towards your financial goals.
Baby Step #4: Invest 15% of Your Household Income Into a Roth IRA and Pre-Tax Retirement Fund
Summary: With this Baby Step, you start saving 15% of your income for the specific purpose of retirement.
Does it make sense? I think 15% is a good target to reach. If you invest 15% for 30 or more years, and keep your living expenses manageable, you’ll have enough to retire.
But if you want to retire early, or if you’re starting later in life, you’ll need to invest more than that.
In that case, what’s more important is to work backwards by first figuring out how much money you’ll need to retire and then identifying how much you need to invest/save to hit that mark.
Another counter argument here is the exclusive use of pre-tax retirement funds vs. investing in taxable accounts. While tax-advantaged funds do work as advertised, the increase in after-tax return is closer to 1% compared to if you just used a taxable account.
This is far less than what most people think.
So, while I’d still take advantage of a 401(k) match, in some cases, it can make sense not to max out your 401(k) beyond the employer match and other pre-tax retirement accounts like an IRA. Instead, put those savings in a taxable investment account.
The idea here is that there are no penalties or fees for early withdrawals from a taxable account. While you will owe capital gains taxes, this allows you the flexibility to withdraw the money for whatever you’d like, rather than having to wait until you’re 59.5 years old, as with a retirement fund.
For many, that added liquidity is worth it.
Tips for success:
- Start with your 401(k) employer match. That’s free money, and you should always take any free money that’s available to you.
- Start where you are. If you can only save a few percent each month, do it. Strive to start with at least enough to get your full company match, so that you aren’t leaving money on the table. Then reevaluate your savings percentage every three months and challenge yourself to add another percent each period. It might take you two, three or even four years to build your way up to 15%, and that’s ok.
Baby Step #5: Save for Your Children’s College Fund
Summary: Having enough money to pay for their children’s future educational expenses weighs heavily on most parents’ minds. With three kids of my own, it’s something I think about often.
Does it make sense? A common mistake here is skipping over Baby Step #4 to start saving for educational expenses.
You have to remember to put yourself first. That may seem like the opposite of what a good parent is supposed to do, but it isn’t. A cash-strapped elderly parent can be a huge burden for an adult child to bear.
Keep that in mind when figuring out how much to save for college. Your kids can borrow money for college at relatively low interest rates, but the same is not true for your retirement.
Tip for success:
- Check in with your state’s 529 college savings plan. These plans offer a tax advantage when saving for your child’s education.
- Use the $2,000 x Age rule-of-thumb. Multiply your child’s age by $2,000 to help you determine the amount of savings you’ll need, or whether you’re on track. This amount covers 50% of the total cost of attending a four-year public college.
Baby Step #6: Pay Off Your Mortgage Early
Summary: For most people, their house payment is their biggest financial commitment. It can be incredibly freeing to pay that off.
Does it make sense? There’s nothing wrong with paying your mortgage off early. But you have to keep in mind the opportunity cost; you might be losing money over the long-term by paying off your mortgage instead of investing more.
This is very true in today’s low interest rate environment.
One other thing to keep in mind is that these two actions aren’t mutually exclusive. You don’t have to choose between paying off your mortgage early and investing more. Say you have $500 left over at the end of the month; consider investing $250 of it and putting $250 toward paying off your home debt.
Tips for success:
- Increase your paydown little by little. Challenge yourself each month to see how many months in a row you can increase your payment, even if it’s only $25 more a month.
- Take advantage of bonuses. When you come across a large sum of money, like a tax refund or bonus at work, put it toward your mortgage.
One strategy that some people use to pay off their mortgage ahead of schedule is velocity banking, in which you take out a home equity line of credit and use those funds to pay down your mortgage in big chunks. You can learn more in this velocity banking guide, which goes into the pros and cons of the approach.
Baby Step #7: Build Wealth and Give
Summary: This isn’t as much a practical step as an acknowledgement that, at this stage, you’ve checked off the big financial goals — which opens up the possibility to do anything you want with your money.
Here, Ramsey uses phrases like, “you can live and give like no one else” and “keep building wealth and become insanely generous.” It’s here too that Ramsey suggests you start thinking about leaving an inheritance.
Does it make sense? This is the point we all want to get to. After years of prioritizing more foundational financial goals, the idea is that once you’re at this stage there’s a world of possibilities.
But is it really that simple?
I’d prefer more guidance on how much one should be saving. Many individuals don’t start their debt-free journey — and more importantly, get through it — until their 30s or 40s. In Baby Step #4, Ramsey suggests saving and investing 15% of your income. Is that enough? I’d certainly run the numbers myself to make sure.
Overall, however, the idea here is solid. This is definitely the point you want to reach — the stage where possibilities open up, and where leaving a larger inheritance or giving very generously can be on your radar.
An Alternative to Dave Ramsey’s Baby Steps
One of the core ideas here at The Ways To Wealth is that personal finance is personal. In other words, there’s no such thing as a one-size-fits-all financial plan.
That said, you can’t deny how much the Dave Ramsey Baby Steps have helped people turn their financial life around. As Derek Tharp, CFP® and lead researcher at Kitces.com points out, there’s a bit of ingenuity with Ramsey’s advice that even financial advisers can learn from.
…from a behavioral change perspective, there is quite a bit of ingenuity within Dave Ramsey’s advice (and the systems he has created to deliver that advice) that advisors may want to reflect on when helping their own clients change their behavior for the better!
So, if given the chance to rewrite Ramsey’s Baby Steps, based on the latest research, here’s my best attempt.
- Step #1: Save a minimum of $500 to cover unexpected expenses while you’re going through Step #2.
- Step #2: Pay off all your high-interest consumer debt (mainly your credit card debt).
- Step #3: Take full advantage of your employer’s 401(k) match.
- Step #4: Save three months of living expenses in a fully funded emergency fund.
- Step #5: Invest at least 15% of your household income for the long-term, understanding the pros and cons of taxable vs. tax-advantaged accounts.
- Step #6: Save for your children’s college fund using a 529 plan.
- Step #7: Build wealth, spend more on the things that make you happy, and give.
Personally, with interest rates so low, I wouldn’t pay off my mortgage and would instead invest in long-term in index funds. Or heck, if I’m on track to reach my financial goals, spend money in a way that can make me happier.
The Dave Ramsey Baby Steps: Final Thoughts
The big value of the Dave Ramsey Baby Step framework is the structure it provides. You can work your way through each of the Baby Steps one by one, always knowing what to focus on. At the end of the day, if you follow the plan, you’ll be in a good place in the years ahead.
But this fixed structure can also create problems, because every financial decision has an opportunity cost. Focusing on becoming absolutely debt free means allocating extra money to your debt paydown efforts, and that may not be the most efficient allocation of those funds.
It’s important to remember that Ramsey is anti-debt as a general rule, and these recommendations reflect that perspective.
Plus, personal finance isn’t always so black and white. Life changes fast. So, from time to time, it’s important to take a step back and analyze your situation to make sure you’re on the right path.
Often, there’s a better path for getting to your goals.