The Thinking Person’s Guide to Dave Ramsey: Swapping Baby Step Order

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.


signpost of financial termsBut 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


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12 Responses to "The Thinking Person’s Guide to Dave Ramsey: Swapping Baby Step Order"

  1. Matt Becker says:

    LOVE this Emily! This is really the essence of financial planning. Rules of thumb are helpful as a starting point, but the best solutions incorporate each individual’s unique circumstances to craft a plan that works best for them. You’re performing a really valuable service here by helping people thing through these things in a little more depth.
    Matt Becker recently posted..How a Single Mother Can Gain Financial Control

    1. Emily says:

      Thanks so much, Matt! Making these decisions is pretty difficult so the attraction to the Baby Steps makes sense, but for those who can handle two priorities I’d rather they concentrate on maximizing net worth.

      1. Aesedai says:

        Emily, what do you think about my situation… I’m in Baby Step 2, I just started and in 9 months I will be finished with the Official version. By then I will owe about 103k which is well below my before tax income of 134k. I was thinking of folding Baby Step 6 into Baby Step 2 since some peoples student debt is more than my mortgage. In the meantime I already do 5% into 401k because my company match is GREATER than 1:1 (meaning I put in 5% and the company adds the equivalent to 6% bringing me to 11%) so it wont be as if retirement savings are at 0. I could be completely out of debt including the house in just under 3 years from right now. Do you think that makes sense?

        1. Emily says:

          Hi Aesedai! Thanks for your comment. Before I give you my view I want to repeat that I’m not a financial advisor.

          I’ve heard people call into the Dave Ramsey show who have done what you’re proposing – just pay off the mortgage quickly and then save for retirement, and Dave really doesn’t rebuke them. So I don’t think getting your mortgage paid off very quickly before starting to invest is a bad plan. As you said, it’s more about the overall length of the debt repayment period (i.e. how long you’re putting off starting to invest) than exactly what the type of debt is.

          But I guess I just have to ask you: why are you so motivated to pay off your mortgage? I’m glad to hear that you are going to stick with saving up to the level of the employer match in your 401(k). But there are some more math details you didn’t add that would be helpful in answer this question. What is your age/how long is it until you want to retire? How is your 401(k) money invested? What is the interest rate on your mortgage? To me, unless there is a compelling reason to get out of mortgage debt quickly, with today’s rates the math is very much on the side of prioritizing investing as long as it is reasonably aggressive. There usually is no harm in just increasing your 401(k) contributions up to 15% (on your side – 21% total) and taking a couple more years to pay off the house.

          But maybe you are not motivated by maximizing your net worth and you just emotionally want to be done with making this mortgage payment. That is probably fine unless you are within a decade-ish of retirement (in which case you need compound interest working as hard as it can for you). I try to err on encouraging people to do what they are most passionate about, and that does seem for you to be paying off the mortgage. If you go that route, just be very sure that once you make that last payment you immediately switch to maxing out all available tax-advantaged accounts. Don’t become complacent because you achieved the goal you are most excited about!

  2. Yeah, I definitely think that the steps can, and should be modified to best suit your life and financial situation. That is, without changing the goals of the program.

    For example, I will be saving 5% for retirement (with a 7.5% match) as soon as I get on with my university… aside from the fact that it’s mandatory, why would I turn down a 150% match on that money?
    Alicia @ Financial Diffraction recently posted..Goals for 2014

    1. Emily says:

      A MORE than 100% match? That’s awesome! I’d say that the biggest reason not to do it is if you plain can’t afford the savings on top of the minimums on your debt payments, but that’s not the case for most people.

  3. I’ll echo Matt’s comments, Emily. I really enjoyed this analysis as I think a lot of people start with a plan like Dave Ramsey’s, but then start feeling the need to modify rules of thumb given their personal situation.

    We went through the baby steps in order, but we did end up investing more than 15% while we were paying down the mortgage. We considered the extra payments to principal as investments, of sorts, so it got a little muddled.
    Done by Forty recently posted..A Case for Outsourcing

    1. Emily says:

      Thanks a lot, DBF!

      Yes, Baby Steps 4-7 are all investments in some manner. And that’s what we’re trying to do here – muddle up DR’s crystal clear plan!

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