7 Baby Steps for Getting Out of Debt
Trying to shovel your way out of a mountain of debt? Popular financial expert Dave Ramsey, the host of the nationally syndicated radio program "The Dave Ramsey Show," suggests that you follow seven "baby steps" as you pay off debt and build wealth. Before covering these, though, check out a bit of background for those of you not familiar with Dave Ramsey.
A Little About Dave
Dave Ramsey grew up in Antioch, Tennessee, studied business administration in college, and graduated with a degree in finance and real estate in 1982. During the next four years after graduation, he founded a real estate investment company and amassed a portfolio of real estate rentals worth over $4 million.
After losing everything and filing bankruptcy in 1988, Ramsey focused on recovering his own financial health and helping others do the same.
Today, his award-winning, widely broadcast radio program "The Dave Ramsey Show" has been on the air for over 25 years, and Dave has gone on to publish several books, offer classes and workshops, make many media appearances, and teach scores of people how to clean up their financial lives.
Now, on to discuss Ramsey's Seven Baby Steps debt-management plan.
Contribute $1,000 to an Emergency Fund
An emergency fund, also known as a rainy day fund, consists of money that you set aside in case of a dire emergency. It's not an account that you tap to go on vacation or buy a new vacuum cleaner. Even if you have massive credit card debt, Ramsey says you should put aside $1,000 in an emergency fund. Then start focusing on your debt.
Why? If you incur a large expense thanks to an emergency, like a trip to the ER or your car dying, that cost could send you straight back into debt. Having $1,000 saved to help you means less of a chance of racking up more debt.
Pay Off Your Debt
Step two is a big step, one that might take years: Pay off all debt except for your mortgage. Ramsey advocates a tactic called the debt snowball. This involves paying debts from the smallest balance to the largest balance, regardless of interest rate. This is a controversial tactic because most finance experts advocate "debt stacking," where you focus on paying off the debt with the highest interest rate first.
However, many people have had success with the debt snowball because this method gives people momentum with their debt payoff. By getting rid of your smallest debt, you feel a sense of accomplishment that can carry through to your next smallest debt.
Additionally, Ramsey advocates for putting all extra income toward paying off debt first, before even saving. In some cases, if you have years of debt payments ahead of you, it might make more sense (especially if you run the numbers) to pay low-interest loans such as student loans more slowly and put some money into long-term investments that yield a higher rate.
For example, if you have student loans with a 5% interest rate and Ramsey says you can make 12% by investing in an S&P 500 Index fund, it makes sense to allocate some of your monthly cash to investing while still paying down your debt.
Build a 3- to 6-Month Emergency Fund
Once you've paid all of your debt off, build an emergency fund that covers three to six months of your living expenses. This will save you from going into debt again in the event you face a major crisis like a job loss. If that seems like a lot, remember that you'll be debt-free at this point, so all the money you were using to pay off your debt can now be directed toward your savings.
Save for Retirement Before College
Think college savings should come before saving for retirement? Look at it this way: Your children can take out loans for college. You can't take out loans for retirement. Put your future first.
Save 15% of Your Income for Retirement
The next step involves putting 15% of your total household income into retirement accounts such as a Roth IRA or traditional 401(k). Don't worry if your employer doesn't offer a retirement plan. You can set up your own individual retirement account or IRA.
If you want to save more, you can; Ramsey just recommends starting with 15%. Increasing that to 30% or even 50% will get you on track for early retirement (depending on your age), which is a goal for some people.
Save for College
Next, start saving for either your own college education or your children's college education (or both). He recommends using 529 College Savings Plans and Educational Savings Accounts (ESAs) as your savings vehicles. Think this should come before saving for retirement? Look at it this way: Your children can take out loans for college. You can't take out loans for retirement. Put your future first.
Pay Off the Mortgage
Now it's time to throw every dime into paying off your mortgage early. Why wait 30 years to finish making house payments? You can aggressively pay down the principal and become completely debt-free, including your home.
This can be a great move for retirement, especially if you plan on living in your current home for the rest of your life. You'll have the peace of mind that comes with knowing you own your home free and clear. No one wants to worry about making mortgage payments in retirement.
Build Wealth and Give
Now you're saving 15% toward retirement (or more), you're debt-free (including the mortgage), and you're prepared to send your kids to college. It's time to focus on building wealth by investing, creating businesses, etc. Don't forget to give to charity now that you're taken care of. The best thing about having wealth is sharing it with others who need it more.