I’ll just start off by saying; I’m a huge Dave Ramsey fan. I think he has some of the best common-sense approach to getting out of debt, getting your personal finances in order, and discovering financial peace. I can’t say I’ve seen a good solid plan for where he goes after getting out of debt and how to invest well, but that’s the point of this blog!
Dave Ramsey lays out 7 steps to financial freedom. Unfortunately the step missing from those 7 steps is what has to happen before embarking on that journey. He talks a lot about it, but it’s really the “Step 0″ of getting debt free. And it’s simple:
Live below your means. Learn to say “No”.
So many people live paycheck-to-paycheck. As soon as they get a raise, they take on more debt, more payments, more subscriptions. They’ll spend every last penny they have and then wonder why they have no money left and can’t get out of debt. They can’t say “no” when a new shiny doodad shows up, or buy the latest car, phone, house, or TV.
This is probably the hardest part of the entire process. You have to be able to say NO. You have to give up trading in to get a new car every year or two. You have to cut out a lot of extra, wasteful spending. I had written earlier about how not losing money is one of the best ways to get wealthy. But it starts with you. YOU have to decide to stop keeping up with the Joneses, to cut back on what you buy, to learn to go lean.
That’s the big step zero, and it’s hard. It may take a full-blown lifestyle change. But trust me, it’s worth it. Even if you don’t go all the way to being “Wealthy”, being debt free is just awesome. It’s absolutely liberating.
So once you make that big leap, here are the next 7 steps to financial peace. Yes, these should look just a LOT like Dave Ramsey’s 7 steps. I’ve added my own interpretation on them to give a second perspective.
0. Stop spending wastefully. Live below your means! Chop of credit cards if you can’t control your spending. Free up some cash so you can proceed through these steps. If you’re spending every last penny, you can’t even take the first step.
1. Put $1000 in the bank. This is your first emergency fund. When little things break or go wrong, don’t put it on a credit card. Pay with money you already have earned. This $1000 helps buffer you from all the little things that would otherwise divert your efforts.
2. Get out of debt (except for the house). Make a list of your debts, smallest at the top, biggest at the bottom. Keep paying the minimum on all your debts (I’m not advocating not paying…) Print out the list! Include everything but the mortgage – we’ll get to that later. Credit cards, personal loans, medical bills, retail cards, student loans, home equity loans, whatever. List them all out smallest to largest. Then start paying them off, smallest to largest. This helps you enjoy some quick wins. Remember when I said print out your list of debts? There’s nothing more exciting than drawing a big red line through a debt when it gets paid off! Post that list somewhere where you can see it every day. After you cross off the first one or two, then it get super exciting! Dave Ramsey uses a terrific term called the “debt snowball” to help you get out of debt. After you take out that first debt, put the money that was going to that loan to the next one on the list! Let’s say you had a loan of $600 with a payment of $50/month and a second loan of $1000 with a $100/month payment. Let’s also say you had freed up $200/month from the step zero. That means you can pay of the first loan in 3 months. Then when going at the second loan, you suddenly are paying $250/month towards it, paying that loan off in 4 months. Then when you go for your next loan, you have $350/month to knock out the next one. On and on it goes until you’re out of debt. Now, some of you might ask about paying off the high interest ones first. My wife and I did that with a couple of our loans, and it still works. But it’s also very important to get those early wins in to get your momentum going and build that snowball.
3. Build your emergency fund. You’re debt free!!!! It’s an amazing feeling. From some statistics I’ve seen, you’re now ahead of 70% of ‘Murica! The cool part is, your debt snowball has probably built up to a pretty considerable amount. When my wife and I reached this step, our snowball had reached around $1000 per month! Now is the time when you want to inflate that $1000 emergency fund to 3-6 months of expenses. That way if you lose your job, have a major expense, you’ll be pretty well covered. For us, this was about $10,000.
In addition, I also started a “car fund”. Shortly after getting married and were still paying off college loans in step 2, my wife and I had a car die on us. We weren’t about to go into more debt for it, but $1000 wasn’t quite enough to get another car. We got lucky in that we had just pulled out an old college-days mutual fund and had built enough cash on hand that was all going to pay off a loan. There was just barely enough there to pay for a new (used) car. From that day, though, I said I would never put myself back in that situation! So I started saving a couple hundred a month and putting it into a low-risk mutual fund. That has now grown enough over a few years that when our next car goes out (which it will… cars don’t last forever), we’ll be ready for it. Similarly, I started a house repair fund, for any major repair needed on our house. Some day the A/C is going to go out. Some day the roof is going to need replacing. And rather dip into the 3-6 month savings, which I prefer to keep in case of layoffs or other misfortunes, I’d prefer to have a separate fund for that too.
Here’s the deal though. You can’t touch these funds for anything but emergencies!!! Christmas presents aren’t emergencies. A new baby isn’t an emergency. Kids needing new clothes isn’t an emergency. A car engine going out more than likely is an emergency. Also, if you have additional funds such as a car, or home repair, or vacation fund, or whatever you choose, those funds are to be used ONLY for those purposes! Don’t dip into the emergency fund to help get a downpayment for your house. Don’t use your home repair fund to buy a fancier car. Don’t dip into the vacation fund to remodel your kitchen! These savings are hard-earned, and important to keep on track. Last note, keep these savings liquid – in other words cash under the mattress or in a bank’s savings account. You’re not trying to get money back on these. Emergencies happen very quickly, and you need to be able to pull them out quickly, and without any penalties.
4. Invest in retirement. Dave Ramsey recommends putting 15% of your income into retirement. While I’m totally on board with doing that, I don’t quite put all that in. Here’s what I personally recommend. If your employer offers 401k options, take advantage of them. Many companies offer matching funds on the first 5% of your income. Totally max that bad boy out! Nothing like a 100% return the instant you invest it! Also max out your Roth IRA contributions. For most people that’s currently $5,500 per year. After maxing both those out, you’re welcome to invest even more into retirement. However for this blog, any additional cash will be necessary for future investments. Hopefully lots more on that later…
5. Invest in education. If you’re planning on having kids or already have some, they’re going to school at some point. School’s not free. High school, college, even grade school can be expensive. Take advantage of some tax-protected investment opportunities and start putting money aside for their education.
6. Pay off the house. Here we are again in debt payoff mode! The exciting part is that once you finish step 3, you almost immediately jump to step 6! You’re almost finished! Just one last wall in the way to being completely debt free. Keep that debt snowball from step 3 rolling and knock out the house early. Every bit that you put towards your house helps as it reduces the amount of interest you end up paying too.
7. Give even more, and build wealth. You’ve finally reached that pinnacle of being completely debt free. Everything you were putting towards debt and then the house is now suddenly freed up! Now is an even easier time to really build more passive and investment incomes. The really fun part is being able to give even more than before. All along this process, giving is always important. Hopefully you’ve been tithing, giving, and helping people. But now that you’re completely debt free, it’s even easier to give more and bigger!
Getting debt free isn’t an easy process. It’s absolutely worth it though! The hardest part is learning to say no and live well within your means. Once you get into the debt snowball, it’s a lot easier and pretty exciting to see those debts start to disappear!
Also, be sure to reward yourself along the way. Obviously don’t go into additional debt for it, and I even highly recommend saving up in advance for it. But give yourself a little something when you finish step 3, or step 6. My wife and I, when we finished step 3, took a long weekend trip to Florida. We finished step 3 with about a $1000 snowball, saved that for about a month and a half, and then spent that on the trip. It was totally worth it, and was an terrific reward for paying off our debt.
So start today. Take it one step at a time. Start on that step 0. Start to say NO.