Our Total Money Makeover

 Posted by on May 21, 2010  Add comments  Tagged with: ,
May 212010

When people learn that we’re debt free (though we’re actually not right now, because we’re paying off medical bills from DJ’s birth. We will be again though, by year-end!), they often ask if we followed the Dave Ramsey system. The answer is no, because we’d never even heard of Dave Ramsey when we started our very long journey to debt freedom, back in 2000. Nonetheless, many of you have asked my opinion of Dave Ramsey’s “Baby Steps” to financial freedom, and a message board discussion yesterday prompted me to finally tackle this topic.

There is much merit in the Dave Ramsey system, and I greatly admire his ability to wake people up and get them to finally take their finances seriously. I also think that his book is written in a way that is simple and easy for most people to understand. I agree with much of what he says, but I don’t entirely agree with all of his “baby steps.” For those of you not familiar with them, here they are, in order, with my commentary below:

Baby Step 1
Save $1,000 to start an emergency fund.

We did this, and I think it’s very important, especially since we’re self-employed, with only one income. In the event that my husband is unable to work, we’ll need a cushion to fall back on. However, while $1000 is a good place to start, it’s not really going to cover much of an emergency. For example, if the transmission goes out in your car, chances are this will barely cover the cost of parts and labor, and then you’re back to square one. I suggest a “baby” emergency fund goal of at least $2500, or if you can manage it, one month’s expenses.

Baby Step 2
Pay off all debt using the Debt Snowball. Start with the smallest balance and work up to the largest. Don’t worry about the mortgage yet.

Dave and I disagree here. The debt snowball is a good idea, and I understand that paying off a bunch of small debts quickly builds “momentum” to keep going, but from a purely mathematical standpoint, this doesn’t make sense. Our goal was to keep as much of our money as possible, so we would have more to contribute to our debt, so we used a modified debt snowball approach. We paid off the debt with the highest interest rate first, and as quickly as possible. We then put that payment amount toward the debt with the next highest interest rate, and kept going until everything was paid off.

Baby Step 3
Build an emergency fund of 3 to 6 months of expenses

Absolutely. Dave gets no argument from me on this one. We have 6 months of expenses saved, and I can’t even describe the peace of mind this brings me. We’ve had to dip into our emergency fund this year because my husband took time off work to care for me, and to help me after DJ was born, and he’s now off because of his knee surgery. I’m very, very thankful for that money right now.

Now, here’s where Dave and I have serious disagreement….

Baby Step 4
Invest 15% of household income into Roth IRAs and pre-tax retirement

Baby Step 5
College funding for children

Baby Step 6
Pay off home early

Baby Step 7
Build wealth and give!

In my opinion, steps 4, 5, and 6 are mixed up, and here’s where I must insert a mini-rant…It drives me crazy when people call into Dave Ramsey’s radio show and claim to be debt free! Yippee! Except they’re not! They still have a mortgage!

I don’t know where these people are getting their definition of  the word debt, because that’s what a mortgage is – it’s debt, and quite a lot of it. Some people seem to have the attitude that because it’s typically secured, low interest debt, it doesn’t count, but it’s still debt. In my opinion, paying off your mortgage should be a priority before maxing out your retirement savings, and certainly before saving for a child’s education, and here’s why:

1) Peace of mind. When your house is paid for, you know that no matter what tragedy befalls you, as long as you can manage to pay your property taxes, you will always have a roof over your head. For many people, including me, you can’t put a price tag on that kind of security.

2) A “guaranteed” investment return. For every dollar of your mortgage that you pay early, you “earn” the interest that you would otherwise have paid on it over the balance of your loan period (typically 30 years for those with fixed rate mortgages). Some people argue that they can earn more interest by investing than they’re paying on their mortgage – in other words, why pay off a 5 or 6% mortgage when you could be earning 8% on that money? Of course, the events of the last couple of years, (some financial experts say the last decade) poke all kinds of holes into that theory. Those returns are not guaranteed, but mortgage savings are.

You must also consider inflation. It erodes the value of the dollar, which means that the money you pay on your mortgage in the future won’t be worth as much in terms of real buying power as it is right now.

3) You’re human. Paying off your mortgage saves you from yourself, so to speak. Sure, it sounds like a great plan to pay the minimum on your mortgage and invest any extra money, but this requires great discipline – more than most people have. You have to actually follow through, and unfortunately many people can’t resist the temptation to use disposable income for cars, toys, and vacations. It’s human nature to feel competitive or envious, and the desire to keep up with the proverbial  Joneses is undeniably strong.

Also, while it’s a lofty and noble goal to pay for a child’s education, it makes absolutely no sense to do so at the expense of your own financial security. My husband and I wish to help our children pay for college, but we expect that they will pay for at least half of their tuition themselves. We have 529 plans for them, and we do save for their education, but we didn’t start to do that until our mortgage was paid. For most people, the mortgage payment is the single largest payment they have, and freeing up that money opens up a lot of investment opportunities. And remember, as our financial advisor pointed out, a 22-year-old college graduate has his or her best earning years ahead to pay off student loans, but this is not the case for parents facing retirement. In our case, when DJ graduates from high school, my husband will be 70! We must think of our own financial security first.

I also think that there are two very important steps missing from Dave’s list:

1) Cutting up credit cards. It’s fine to keep one low-interest card for emergencies, but remember that these steps are for people who are in debt. There is discussion in the comments about how credit cards are beneficial as long as you pay them off in full every month, and I agree, but typically people who incur significant consumer debt lack that kind of discipline and restraint. It can be learned and achieved, but I think it’s best to eliminate the temptation of easy credit.

2) Doing whatever is necessary to live within your means. Many people have no hope of ever paying off their mortgages, because they’re living in houses that they can’t really afford. In this country, so many people live far beyond their financial means, and if they were to “trade down” into a more affordable house, they would be more comfortable, and it would be so much easier for them to actually pay off debt.

So, there you have it- my humble opinion. I don’t completely agree with Dave, but honestly, all nit-picking aside, the point of the Total Money Makeover is to buckle down and pay off your debt, any way you can. To sit up and pay attention to your finances. The goal is to achieve financial peace, and if you want to do that Dave’s way, I say go for it. Regardless of how you get there, financial freedom is a beautiful thing.