This is the fourth installment of this series on reasonable way to adapt Dave Ramsey’s Baby Steps program to fit your financial goals.  You may want to reference last week’s post on intra-Baby Step modifications to familiarize yourself with the steps before we dive into this week’s discussion of inter-Baby Step modifications.

The big difference between Dave Ramsey’s approach to managing debt and investments and other financial professionals’ is that Dave Ramsey does not care about interest rates.  We saw this in the debt snowball because the debt balance is the sorting factor instead of interest rate, but we also see it in that he wants all debt paid off before beginning investing.

The choice to ignore interest rates in the Baby Steps makes sense from a marketing standpoint because that means the advice can be used without regard to the overall financial environment.  Dave Ramsey doesn’t have to give different advice when interest rates are low, like now, from when interest rates are high if he sticks with a universal approach.  It makes the decisions very simple for the participant in the plan, which is one of the underlying principles – they don’t have to analyze the overall financial climate to make decisions about debt and investing.

But when the pendulum has swung so far to the low-interest-rate side, as it has right now, and we’re experiencing a crazy bull market, it is questionable as to whether Dave Ramsey’s advice should be applied in any climate – perhaps it is more appropriate in a higher interest rate environment, when interest rates on debt exceed the long-term expectation of market returns.  Right now borrowing costs could be even less than average inflation!  This mortgage interest rate environment, Dave Ramsey has said numerous times on his radio show, is unique in his lifetime, so perhaps his program is not flexible enough to encompass this unique environment.

If we decide to take into consideration the interest rate on debt as well as the possible return on investments, that would lead us to perhaps swapping parts of or entire Baby Steps around.  The Baby Steps as currently ordered are very appropriate for someone who has high-interest debt, whether non-mortgage or mortgage, in this environment, even if the interest rates on the debt would have been considered moderate or low in previous environments.  After all, I’m using this framework to coach people making financial decisions now, not in the ‘80s.  But for those who have other variations on that basic model, there are ways to adapt this program to make it fit your situation.

Scenario 1: You have high-interest rate debt.

This is the scenario best suited for following the Baby Steps as Dave Ramsey prescribes.  If the interest rates on your non-mortgage debt are higher than what you would (be reasonably assured to) get in long-term investment returns, you should pay down that debt quickly before starting to invest.  If refinancing your mortgage is not an option, it is a good idea to split focus between long-term saving and paying down the mortgage.

Scenario 2: You have low-interest rate non-mortgage debt.

With low-interest rate debt, it is reasonable to move up investing and possibly increasing your emergency fund size.  If you feel comfortable keeping the debt around and just making the minimum payments, you can pile the money you free up by being gazelle intense to go toward high-return investments, in or out of retirement accounts.  If you determine that you can’t sleep at night with just the $1,000 baby emergency fund in the bank, you could also prioritize saving the full-sized emergency fund over paying off very low-interest rate debt.

Scenario 3: You have a mortgage with a low interest rate.

If the rate is low enough, why not just make the minimum payments and invest everything extra that you would have put toward the mortgage?  You could return to paying it off faster after maxing out all your tax-advantaged accounts, or you could continue to invest in taxable accounts.  The same logic we used when exploring the 30-year vs. 15-year mortgage applies here.  This is basically the elimination of step 6 and moving straight to step 7, investing beyond that 15% toward retirement.

Scenario 4: Your employer offers a retirement match.

You can think of a retirement match as a guaranteed return on your investment, whether it’s 100%, 50%, or some other ratio.  A 50% return beats any kind of interest rate on non-payday loan debt, so there’s an argument to be made that a match should never be passed up on, even while repaying debt.  At least up until the cap on the match, it’s reasonable to move Step 3 up into Step 2 basically regardless of the interest rate on the debt.

Scenario 5: You can sleep at night with the baby emergency fund, have no debt and are eager to get started investing.

I’m essentially advocating doing steps 3 and 4/5 simultaneously, if you are comfortable with a smaller ($1,000) emergency fund.  It will slow down your progress toward the full-sized emergency fund, but you gain the advantage of compound interest on your investments in the meantime.  This is what we personally practice – we save for retirement even though we don’t have our 3-6 month emergency fund earmarked.  We don’t think we need so much in savings, at least not at the expense of the time value of money we’d lose out on by delaying investing.

Scenario 6: Your kids are going to college soon and you have little to no retirement or college savings.

That’s tough luck for your kids.  Do not jeopardize your retirement to pay for their educations.  If you fail to fund your retirement, who do you think is going to be taking care of you in your old age?  Give your kids the gift of your self-sufficiency later on, even if that means they have to find an alternate way of paying for college.  In other words, do not move step 5 ahead of step 4.  (This is extremely standard financial planning advice, even though it’s hard for parents to hear.)

Of course all the alternative suggestions I make above are just options to change up the Baby Steps slightly to customize the program for an individual situation and individual interest rate environment.

The thing is, even Dave Ramsey cares a little bit about interest rates, in combination with balances, vs. rates of return.  If he were purely about paying off debt, he wouldn’t excuse mortgages from Step 2.  By putting investing (steps 4 and 5) before paying off the mortgage (step 6), he’s acknowledging that it’s a bad idea to put off saving for retirement for many years, particularly for (typically) lower-interest rate debt like mortgages.  So why can’t that kind of thinking apply to non-mortgage debt?  Well, Dave Ramsey wants that singular focus, so he doesn’t want to mix up debt repayment and investing for the long-term.  But if you’re capable of splitting your focus between two or more goals at the same time, you can re-prioritize the Baby Step order according to interest rates on debt and expected rate of return on investments (more on that next week).

Which Baby Steps did or would you swap the order of?  What do you think of taking ‘timeless’ advice in this unusual interest rate environment?  Did you start saving for the long-term while still in debt? 

photo from Free Digital Photos