In the last blog, we delved into Dave Ramsey’s Baby Steps 1-2 and I added my personal twist on them that brought me out of debt as well as helped pay off 200K of student loan debt, build an emergency fund, retirement, and college savings. Today, we’re going to finish exploring Baby Steps 3-7 to figure out how to make it work for you and your life.
Let’s start by reviewing Dave’s Baby Step program:
**Steps 1-2 covered in blog post on 5/25/21, click on link to read before continuing https://realpamelaferguson.wixsite.com/website/post/breaking-down-dave-ramsey-s-baby-steps-1-2
Step 3: Save 3-6 months of expenses (full emergency fund)
In Step 2, we talked about tackling debts as well as dipping your toe into Step 3 at the same time. Let’s review the debts mentioned in the previous blog post. Dave Ramsey would recommend complete focus on the debt, but I would make an adjustment once the high interest credit card debt of $10,000 is paid.
A-$10,000 credit card debt at 18.99% APR
B-$9,000 car loan at 3% APR
C-$15,000 student loan at 4.5% APR
I have the mindset that if you can make more money in investments, you should do just that. That being said, I am also adverse to debt. So, now I have to square these two items. I do that by splitting things out once I pay off the super high interest rates (18.99% in this example). The previous example had $3,000 extra/month to pay off debt. Start by taking $20 off the top for charity and then use 90% of that money ($2,682) and pay off the student loan (if you’re doing the Avalanche Method) or the car loan if you’re following the Snowball Method. Then, take the remaining 10% ($298) and sock it away to work on Step 3. I like this tact because your focus is still paying off debt, but you’re also taking baby steps (pun intended) to build savings at the same time. The 90% is arbitrary and you could easily use 75% and that would be ok too. Find an amount that you feel comfortable with. If you have a large amount of debt, I would lean toward the 90%. **I will recommend a modification if your company does 401K matching. See next step for more details.
The key to putting money aside for your emergency fund is ONLY IF you’d be making more in earned interest than you’d be paying. In this example, it’s highly likely that you’ll be able to make more than 5% in interest, so that’s the reason that I would feel comfortable working on both steps together. An exception would be if your savings venue did not yield more than what you’re paying on your debt. If that is the case, you should NOT direct the money toward other savings options. Review the blog Miscellaneous Savings for Kids to find out more savings options. https://realpamelaferguson.wixsite.com/website/post/miscellaneous-savings-for-kids
The next reason you should not do this is if you’re not disciplined enough to do the financial calculations every month and adjust when needed. If you’re more of a “follow directions exactly” kind of person, then just knock out all of your debt before going to Step 3. However, if you can see and implement the bigger picture, I’d recommend the combo plan.
Once you finish all of your debt, it is likely that you will still have more emergency fund to build. So, you can now work Step 3 in conjunction with Step 4 just as we did with steps 2 and 3, but now the largest percentage goes toward the emergency fund. The co-star becomes the star. You can use the same percentages as you did previously (90/10) or decide on an amount that works better for you.
Step 4: Invest 15% of your income for retirement
Let’s begin by stating that the maximum amount that you can contribute into your 401K (company sponsored retirement plan) in 2021 is $19,500. If you’re over 50, it caps out at $26,000. If you don’t have a company sponsored retirement plan or want to set aside additional money, the maximum contribution for a Roth or standard IRA (Individual Retirement Account) is $6,000 and for those over age 50, $7,000. If you are self-employed, you would instead have an option to get a SEP (Simplified Employee Pension). The 2021 amounts are 25% of the employee’s salary or a max of $58,000. Important to note that 401 is pre-tax dollars; that means even more savings for you.
If you’re into Step 4, you are already on the road to success. At this point, you know how I roll with finances and how I like to do percentages to achieve my goals. Even though retirement is Step 4, you may already have built some long-term savings (retirement) while in Step 3. Why would you be doing Step 4 before completing the other previous steps? This is a tricky one. If you are with a company that does 401K matching, I would recommend putting the full amount of the match in. That means that if your company matches 3% of your salary, you should put 3% of your salary in your company’s retirement plan. Otherwise, you’re literally losing out on FREE money.
After you have paid your high interest rate debt (the $10,000 credit card in this example), insert the company match here—yes even before the emergency fund is complete. If you have this option at your place of employment, you should consider an 80/10/10 rule where 80% goes to paying off lower interest rate debt, 10% toward the full emergency fund, and 10% toward your 401K until you reach the match amount.
When your emergency fund is fully funded, it’s time to work on another split (oh, dear Lord, again? Yep!). You can do this is tandem with Step 3. **There are several levels of savings that are not mutually exclusive. You have your emergency fund, which is more short-term and long-term savings of retirement. You want to be able to fund all of the different level of savings because they all serve a different purpose.
Step 5: Save for college for your children
Step 4 and Step 5 continue to work together. Step 4 is having you continue to invest in your retirement (401K, SEP, IRA, Roth) and that doesn’t go away. Meaning that you stay at Step 4 until you have additional money for Step 5. For many, that may never happen. Many people will not have that much extra money, realistically. Even if you don’t overspend, that is a large amount, even for those making a decent income. We hope to get raises to create more disposable income, but there is no end to your retirement contributions. That is, of course, until you actually retire. It’s important to add that if you have multiple children who are close in age, saving for college can be even harder.
How are you going to ever get to the other steps unless you get huge raises? Very good question. If you have no more debt (besides your home), have sold and scrimped every place possible, how are you going to get extra money for helping your kids? I can see how it may seem like an unscalable mountain.
Ask almost any financial planner about saving for college and retirement and the majority, if not all, would say that you need to fund your retirement before your child’s college. I have believed this for years. After all, you can’t get a student loan for retirement. However, I currently have a freshman in college and a HS senior and now fully understand the sheer mass of expenses as it relates to higher education. I do not believe that they’re mutually exclusive though. I think you can do both.
If you have to pay off all debt, build up 3-6 months for an emergency fund, set aside 15% of your salary for retirement before you can even begin saving for college, it might never happen. This is one of the reasons I believe that Steps 3-5 (and a little 6) should work in conjunction. It may seem overwhelming to think about trying to do more than one thing at once and, to be honest, it can be. I’m hoping that by the time you get to this point, you’re able to do some more complex planning. For any of these recommendations, if it feels overwhelming, simply stick to the standard Ramsey Baby Steps.
Step 6: Pay off your home
This is the last step in paying off debt and can take a very long time. However, with no debt and money already set aside, extra money can go here.
Step 7: Build wealth and give
As mentioned earlier, giving back should begin from day one of your finances. However, this is the time that you can even give more to those wonderful organizations that you back. Building wealth should always be on your mind in making smart decisions for your future or that of your family.
Let’s walk through the entire example and process with actual numbers.
Salary of $50,000 and $3,000 extra per month to pay off debt.
A-$10,000 credit card debt at 18.99% APR
B-$9,000 car loan at 3% APR
C-$15,000 student loan at 4.5% APR
1) Take $20 toward charity (over time, it can increase). It’s ok to start small. $3,000-$20 = $2,980
2) Fund beginner emergency fund your very first month, $2,980-$1,000=$1,980 (rest to debt)
3) Pay off debt using the order, A, C, and B. Credit card is paid off in less than 4 months. Once high interest rate item is paid, put 80% ($2,980) x.8=$2,384 toward student loan, 10% ($298) toward full emergency fund, and $298 toward matching 401K amount through your employer. You will pay off all listed debt within a year and build an emergency fund of $3,576 (without interest). I also recommend rounding up your mortgage to the next whole number. For example, round your housing payment of $1,041 to $1,100. **If your company does not offer a matching program, skip this part and do 90% toward debt and 10% toward emergency fund.
4) Once ALL debt is paid, shift focus with the primary amount being toward the emergency fund while continuing to add to retirement. This is $2,980 x .9 (90%) = $2,682 toward emergency fund and 10% ($298) toward 401K. **Note that if your salary is $50,000 and your company will match up to 3% of your salary. The annual match amount is $1,500, or $125/month and it’s very doable from our calculations. You actually don’t even have to take a full 10% in this example. It would instead be $125 toward company 401K and $2,855 toward emergency fund.
5) Once you have fully funded your emergency fund, continue with the percentages, but focusing on your retirement and children’s college fund. $2,980 toward retirement and $298 toward college savings. Dave Ramsey recommends setting aside 15% of your salary for retirement. In our $50,000 salary example, this would be $7,500/year or $625/month. So, if you had $2,980 per month for savings, $625 would go to retirement and then you’d have $2,355 for other savings options. Fifteen percent is good, but I think that you should max out the annual amount allowed by law (listed above). That means that you’d set aside $1,625/month (max of $19,500<age 50) leaving $1,355/month for college savings or $2,167/month > age 50 leaving $813/month for college savings.
6) Since you don’t “finish” your contributions to retirement and college savings—at least for quite some time, it can be hard to work on paying down your mortgage. Rounding up can help with this a lot. If your loan is $1,041, round up to $1,100 for one year, then $1,200 the next, etc…
I know that I went through a lot of crazy calculations and percentages in this blog. The percentages may not be for everyone because it may be overwhelming. If that is the case, simply stick to Dave Ramsey’s Baby Steps and figure out if you want to use the Snowball or Avalanche Method as it relates to paying off debt. Feel free to reach out to me and I’d be happy to look at your personal situation and give you FREE guidance.
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