So, after reading this blog, I know you’ve been learning and saving wherever you can and have cut down on your expenses leaving more money in your pocket. Now that you’ve made some space in your budget, what do you do with the extra money? Having extra money does not mean that you can spend more money.
Dave Ramsey is a renowned financial guru that has brought thousands out of debt. An incredible guide and mentor that has been a Godsend to so many. I think the organization is amazing and gives incredible tips. I wanted to break down The Ramsey Baby Steps program and discuss the specific details. I’ll also address the items that I agree with and the ones that I think could use a little tweaking. Since we have so much to cover, we’ll break it down into two segments. Step 1-2 and the remaining steps will be covered in a future blog post.
Dave Ramsey begins at Step 1, but I believe that we need to first talk about a mindset that should come even before Step 1. It has to do with giving back and to me, it should even be before the first step in your financial game plan.
Before Step 1:
If you’re in debt and struggle financially, it’s understandable that your first thoughts are paying off debt and increasing savings. I would agree with this on principle. However, for me and my family, the first thing that needs to come off the top before you decide to do anything with your extra money is to GIVE BACK. I know that it may seem counterintuitive when you’re struggling with needing extra money in the first place, but I believe that it’s much harder to start giving after the fact than before. It’s way too easy to rationalize and delay this pre-step, but I believe that it’s a very important one.
Whether you think about it as Karma, the law of attraction or simply just the right and moral thing to do, giving back is a habit that you want to start. I know that we’ve all heard the 10% of your income for tithing or giving back, but you may not be there yet. Instead of a strict percentage amount, I would recommend starting out with a small amount like $10 or $20 from each check. Choose a wonderful organization or church to give your money. Not only is this a good practice to start immediately, but there are personal benefits to doing so as well. You can help make an impact in your local community, lower stress, feel happier, and even improve your health—studies show that volunteering and giving back makes people feel healthier. And that doesn’t even include tax benefits. Ever since my teens have started working, I have implemented this for them as well. Start them on the right habits right away.
Once you have implemented “Before Step 1”, you’re ready to add in Step 1 to the mix.
Step 1: Save $1,000 (beginner emergency fund)
With all of the tips I’ve given you on this blog so far, you should now have some extra funds beyond your normal expenses. After you take out your charitable giving, take any additional money and set it aside to build a beginner emergency fund. This is an important step for small emergencies. We all know that $1,000 won’t cover all emergencies, but it will cover things like a flat tire, battery replacement, and small car repairs. I agree with Dave on this one and think it’s a good idea to start with a small amount of savings before tackling debt. If you don’t have money for the small things, you still may incur more debt. Important to note that if you do have to use part or all of the beginner fund, you should move back to Step 1 until it’s back to $1,000 and then continue forward.
Step 2: Pay off all debt (except home) using Snowball Method
Pay off your debt! I am one of those people who hate having debt. It’s almost an obsession. I just don’t feel comfortable being extended like that. Dave Ramsey recommends the Snowball Method. What that means is that you take ALL of your debt (student loans, credit cards, car payment) except your home and list them out from lowest to highest in balance, regardless of interest rate.
There is a debate on whether you should pay off debt using the Snowball Method that Dave Ramsey subscribes to or the Avalanche Method. Both involve listing all debts and focusing on one, but they differ in which order they should be paid. The premise for both is that you pay the minimum payment on all debts except for the main debt where all remaining money is applied.
As mentioned, the snowball method is starting with the lowest balance first and moving from there. Differing is that the Avalanche Method ranks the debt from highest to lowest based on interest rates and not balances. There are pros and cons to both. The Snowball Method costs more in the long run, but yields quicker results, which can be helpful if you struggle with motivation. With the Avalanche Method, you will pay less interest over time, but progress may be slow at the beginning on reducing the number of debt items. It requires more discipline than the Snowball Method.
Let’s look at illustrations using both methods to clarify the differences. In this example, your debts are as follows and you have an additional $3,000 per month (that would be nice!) to devote to extra payments every month.
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
The Snowball Method has you paying B, A, and C in that order. You would start with the lowest balance of the car loan and then pay the remaining debts once removed. You’d eliminate your car loan in 3 months and then can focus on the other two. It would take approximately 11 months to eliminate all of this debt. With this method, you would pay $1,514.97 in interest during this time frame.
In contrast, the Avalanche Method has you paying A, C, and B in that order. You would start with the high interest credit card debt which when completed, you would be able to pay off the remaining items in 11 months and be debt free. The BIG difference is how much you’ll pay in interest over that time frame. The total amount that you pay in interest would be $1,011.60 using this method, which is over $500 less than using the Snowball Method. So, just by changing the order in which you pay your debts, you can save a considerable amount of money (in this example). So, if you have a large amount of debt, you can save even more and will probably reduce the total amount of time needed to pay off the loans as well.
The Avalanche Method is clearly the financial winner, BUT… if you have a problem staying motivated and paying off debt, it can leave you feeling defeated. It is not uncommon to have a debt with a high interest rate AND a high balance so it may seem like forever before you get rid of it leaving you frustrated about not making any progress. No one (except maybe me) gets excited about paying off debt and if you don’t see progress, you may want to throw in the towel because the climb seems insurmountable.
The American need for instant gratification is a plus for the Snowball Method and makes it more effective to stay motivated. Dave Ramsey feels that even though the math leans more toward the Avalanche Method, paying off debt is 20% head knowledge and 80% behavior. Quick wins keep you pumped up to continue. Plus, it’s easier to implement, especially if you have limited knowledge of financial “stuff.”
It’s basically either financial or psychological. I’d personally rather have you pay more overall and continue paying versus get exhausted with the process and give up. We know that sometimes people aren’t always rational with money—head versus heart. If you feel this may be you, the Snowball Method is the way to go.
I tend to be more in the Avalanche camp with a little bit of Snowball sneaking in. What the heck does that mean? Well, I want you to list your debts by interest rate from highest to lowest. Then, I want you to look at interest rates that are close to each other. Let’s examine this further with a more complex example of debts.
1) $10,000 credit card debt at 18.99% APR
2) $1,500 credit card debt at 13.5% APR
3) $7,000 furniture loan at 5% APR
4) $15,000 student loan at 4.5% APR
5) $36,000 student loan at 4% APR
6) $9,000 car loan at 3% APR
In general, I do agree with the order listed above. However, I’m going to throw some Snowball in the mix for the close ones. So, take a look at the $1,500 credit card at 13.5% APR. Even though it’s #2 on the list, I would recommend paying this off first since it has a considerably lower balance and you could knock it out after only one month which would allow you to move that minimum balance to the next debt. The next one gets tricky. #6 has the lowest APR, but there is a large difference between #4 (the 15K student loan) and #6. Since the interest rates are fairly close, I’d recommend moving it up a few slots. The final schedule would then be as follows. **Personal preference is how you choose to order debts.
1) $1,500 credit card debt at 13.5% APR
2) $10,000 credit card debt at 18.99% APR
3) $7,000 furniture loan at 5% APR
4) $9,000 car loan at 3% APR
5) $15,000 student loan at 4.5% APR
6) $36,000 student loan at 4% APR
I would also make another modification, but not related to the order. Getting rid of debt is very high on the priority, but so is building an emergency fund and your savings. Maybe it’s due to my undiagnosed ADHD (joking…maybe) or the fact that I like to multi task, but I think that you can work on Baby Step 2 and 3 in tandem. Once you get passed the high-end interest debts (those darned credit cards), you work Steps 2 & 3 together. You would do this would by taking a percentage and splitting the amount of money you have extra per month. In our example, you had $3,000 extra. I would take 90% (not set percentage), or $2,700 to put toward paying down debt and then $300 toward building your full emergency fund. I know that this will take slightly longer to pay down your debt, but you’re paying off debt and building savings at the same time. Some would disagree with this, but if you choose a savings avenue with strong returns, you’re earning more than you’re paying. Regardless, you’re only putting a small percentage to the next level anyway. If this is too confusing for you, stick directly to either the straight Snowball or Avalanche Method.
Overall, I think Dave’s Baby Steps are amazing and give great guidance. I think they offer a celebrated outline to follow, especially for those who may struggle with figuring out the small details. In our next blog, I’m going to continue exploring his baby steps in more detail to pick out the best parts and to make them more effective for the regular person, in my opinion. Happy stepping!
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