Updated on 10.25.07

A Deeper Look At Dave Ramsey’s Seven Baby Steps To Financial Freedom – And How They Apply To Us

Trent Hamm

In a recent discussion about why I’m looking at paying off debt in the short term over investing, a reader mentioned Dave Ramsey’s book The Total Money Makeover, which basically encourages everyone to follow these seven steps to financial freedom:

1. $1,000 to start an emergency fund
2. Pay off all debt (except the home) using a debt snowball
3. 3 to 6 months of expenses in savings
4. Invest 15% of household income into Roth IRAs and pre-tax retirement
5. College funding for children
6. Pay off home early
7. Build wealth by investing

These steps were debated rather vigorously in the comments, with some people thinking that these were a great idea and others discarding them as rubbish. I thought I would give my general thoughts on them, especially as they apply to our personal situation.

First of all, in April 2006 we were at step zero on this plan. We hadn’t done any of these, a few of our bills were late, and we were feeling rather desperate. The culprit? Overspending.

Since then, we built up our $1,000 emergency fund, paid off all of our debts except our student loans and our mortgage, moved into a house, got four months’ worth of living expenses built up, started putting more than 15% into our retirement plans, and started a well-funded 529 for both of our kids. In other words, we completed steps one, three, four, and five of Dave’s plan, and largely completed step two (we still have a few student loans, but no consumer debt).

Thus, my real decision was between jumping ahead to Dave’s seventh step or going back and finishing up step two and working on step six. I think that most people would agree that steps one through five make a lot of sense – build an emergency fund, get rid of all of your high-interest debt, build a strong retirement plan, and fund college for your children. After that, it gets a little bit hairy.

For the long term, it usually makes sense to jump into investing at that point, if your only debt is your mortgage (in our case, we lumped student loans in with the mortgage because they’re fixed rate loans below 8%). With a time horizon of better than ten years, making minimum payments on your loans and investing for the long term will net you more money.

However, investing first assumes that you are not considering any significant lifestyle changes and are planning on steady income. The rules change in our case, because we are strongly leaning toward a stay-at-home option for one or the other of us. Thus, even though we have a long time horizon, our shorter-term goals (being a stay-at-home parent for a short period) have more urgency than our longer-term goals – our children are only young once, and when they’re in school, we both plan on working again. We still plan on looking for that country estate, but it’s worth it to us to push it off for a few years so we can provide a strong personal foundation for life for our children.

Because of that, focusing on debt reduction, as per Dave’s plan, makes more sense to us. It reduces our monthly bills by a significant factor (eliminating all of the student loans before one of us stays at home will reduce our bill load quite a bit) and our “investment” in debt repayment does pay 7-8% guaranteed (depending on the interest rate of the student loan).

So what about Dave? Dave Ramsey’s plan is a brilliant starting point, particularly if you’re completely unsure about what to do with your financial situation, but it is not gospel. Different situations require different plans – there is no “one size fits all” financial planning solution. If someone tries to sell you one, run away fast.

The debt turnaround that my wife and I experienced over the last year and a half opened this door for us. Without really discovering frugal living and the value and need to get out of debt, we would never be in a situation where we could realistically consider one of us making a major life change. Regardless of the decision we make here, our foundation is far, far more solid than it was eighteen months ago.

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  1. miguel says:

    How can you get a better return on your investment by not paying off your debts (student loans) before investing? Don’t you actually bleed money maintaining your student loans rather than investing?

    Also from a risk viewpoint isn’t paying the debt off a guaranteed way of earning a decent return?

  2. dawn says:

    Isn’t this whole financial success thing all about acquiring the knowledge then using it to our best advantage? Congrats on adapting Dave’s formula to fit your family’s needs. We don’t need to get hung up on “a magic formula” because there really isn’t one.(Except of course the golden rule of living below your means).

  3. miguel says:

    I guess I should mention that I’m not implying, or accusing you of anything from my comments above, but I’m wondering this myself as I have a really low interest loan I am thinking about paying off with savings.

  4. Chef says:

    Paying off any loan above 6% is always smarter than investing. There’s a reason that no investments offer guaranteed returns greater than 6%. If you have the ability to generate those returns, why think that you can outsmart Wall Street.

  5. wealthy_1 says:

    I just want to commend you and your wife for working as a team and making decisions together. I’ll bet that’s the reason that you have experienced the financial success that you have.

    I say get out of debt. You’ll feel like you lost 10 pounds!

  6. Wendy says:


    If you put money towards paying off a 3% loan, you make a 3% return on your money because that is 3% in interest that you won’t be paying later. However, if you have that money in a high interest savings account (I used EmigrantDirect, currently 4.75% APY), you make a total 1.75% on the money in that account by not paying off the 3% loan immediately. You gain 4.75% put lose 3%.

    What I infer from Trent’s post is that he expects his investments to return greater than his 8% loan over the long term.

    Again, this is a numbers game, and it all comes down to how comfortable you are with debt of any kind. Certainly pay off that 3% debt if you’ll sleep better at night, but I wouldn’t do it for the world.

  7. wqbang says:

    Dave Ramsey’s plan isn’t perfect for everyone… but it is designed to be “workable” for everyone. Really and truly you can’t go wrong following his plan – it is not bad advice considering that it isn’t a custom tailored plan. With all things, take what you need and tailor to fit. The real power in the baby steps isn’t the actual financial steps, it is the emotional changes that are fostered that actually radically change lives.

    Arguably step 1-5 are almost no-brainers. Step 6 and 7 are up to the individual.

  8. Moneymonk says:

    Looking at Dave’s plan. I did step 1,3,4,5 and 7

    I still have student loan debt, however it will be paid off in a year.

    Like you said it all depends how comfortable you are with debt.

    I rather paid off my student loans in a year, (My job is very safe) than to take $10K of my acct and pay it.

  9. Mrs. Micah says:

    I’m a big fan of people applying his steps to fit their lives/needs. I’ve written a couple pieces on how we modified his plan for us. For us it was because of the amount of time (more than 2 years) we’d need to pay it off even at his intense rate (shoot, it’s 4 times my current annual salary) and the comparative uncertainty of my employment.

    I think you did an excellent job adapting it to your current plans and situation.

    Good points, Wendy. If he gets more than 8% returns it’s good. With higher interest, then it’s worth paying off to get that “guaranteed return” and also not acquire more debt.

  10. pbmax says:


    Your 4.75% is taxable, making your real return more like 3.3%. So, you have debt risk for a third of a percent.

    No thanks.

  11. Baba Ghanoush says:

    Wow! You’ve come a long way in 18 months! I know that has to feel good.

    I’d say my invest vs pay off debt threshold is somewhere around 6%. So if my loan interest rate is below 6%, I pay down the debt. That’s based on gut feeling that I’ll likely earn around 7% after-tax on investments. Paying off debt is a guaranteed return, which counts for a bit, thus 6% for a final figure.

  12. Stephan F- says:

    There is a big difference between investing and knowing what you are doing when you invest. We are at step 3.

    We did some investing and that did not work out very well. I know we don’t know enough to do it well yet, but we are learning. If it is on the cover or Time and on the TV a lot it is time to get out, not in. Index funds maybe great in the long run but they take a beating from time to time and that can drive you nuts.

    We are taking care of things that are important and leaving investing for later but doing some learning now, so we’ll have a better idea of what to do when we get that far.

  13. miguel says:

    How do you account for taxes and inflation?


  14. kalispender says:

    So, if you haven’t bought a home yet, how does this list change? I definitely would put it before the college savings (seeing as how I don’t have any kids yet). But, where does it stand against retirement?

  15. I love me some Dave. Because I didn’t have debt, I sort of feel like I’m following his steps–even though I’m not, quite, because I haven’t stopped my 401(k) contributions while I save up my emergency fund.

  16. Red says:


    My student loans have *below* a 3% interest rate, which means even keeping my money in my 5.0% savings account instead of paying extra on my loans makes me money over the period of the loan.

  17. Mark says:


    Same here, my student loans are consolidated at 2.25% tax deductible interest, so the effective rate is somewhere around 1.7%. It would be very foolish to pay this off early, like you said, I could earn much more than this in my ING or HSBC account. I can make no logical argument for paying these off early.

    Also, my mortgage is 6.00% tax deductible, so about 4.5%, I can still beat that with an online savings account. I could most likely double that return with higher risk investments.

    So, for me anyway, the answer is easy, just make the minimums on my debt and save the rest.

  18. Wow! Some of you guys have really low student loans rates. Mine are 7+%.

    I agree with Trent and most of the comments here. The Ramsey plan is a great starting point. Most people just NEED A PLAN. Any plan at all will be a big improvement for them. I started with Dave’s plan because that was all I had. Now that I’m working on my finances and making progress, I see some parts that I wish to modify as well. For example, I plan to boost my emergency fund nicely once my credit cards are paid off. Then I just have student loans and a mortgage to work on.

  19. Dave Ramsey himself frequently says that personal finance is personal, though I wouldn’t say he ever advises anyone to go through the sequence in any other order than what he says.

    *However*, throughout Total Money Makeover and his previous book, Financial Peace, he maintains that step 2 does not necessarily include the mortgage or student loans if they are more than 50% of your annual take home pay. Both of those get moved to step 6–pay off the home early and pay off student loans with all the money you’re no longer spending everywhere else.

  20. miguel says:

    OK, now that you show the numbers, student loans do make sense to not pay off early.

  21. MVP says:

    @ English Major, I think it’s only recommended that you stop your 401K while you’re paying off debt. Since you have none, you’re fine. We stopped while paying off debt, and now put it back up to the company’s 6% match until we get our 6-month emergency fund built. Then we’ll bump it up to the recommended 15%.

    About Dave and his plan: we LOVE him. His plan has worked wonders for us and we feel totally in control of our finances since we’ve been following it over the past couple years. If that makes us idiots, then so be it. No, I don’t consider Dave a God or anything, and I don’t follow his plan blindly, but it’s simple, easy to follow and it works. There’s no scam involved, you don’t have to pay money to try it out. It just works (for us).

  22. TV Girl says:

    I have a student loan at 8.25% and another at 5.625%, and I’d love to know where the crossover point is between when it’s better to pay it down and when it’s better to save. Does anyone know if there’s a calculator somewhere for figuring out what the effective interest rate of a student loan is after factoring in the tax break?

    I’m a long way from making that decision (I’m still paying down credit card debt), but I’d love to know the answer.

  23. plonkee says:

    ‘Dave Ramsey’s plan is a brilliant starting point, particularly if you’re completely unsure about what to do with your financial situation, but it is not gospel.’

    And this is my general problem with DR – he treats his plan like it is gospel. Still at least I’ve established today that he doesn’t recommend mutual funds for a 1 year time frame, so that’s something.

  24. lorax says:

    I wouldn’t attribute this to DR, he’s mostly selling common sense to debtors. Pick up “Personal Finance for Dummies” and you’ll read practically the same thing, better presented.

    I do agree that paying down the mortgage is a pleasant psychological boost.

  25. Amanda B. says:

    Wait, there is a leap here that some people are making that I think is missing the point. You can make more money putting extra cash in a savings account at 5% than paying off a loan at 3%. With this plan you are also quite safe. However, when you then say “I could most likely double that return with higher risk investments”, you have taken saftey out of it. Investing with your extra cash is good if your risk tolerance allows it, but it is clearly not the next step from earning 2% more interest in a savings account.

  26. Wish I heard of him sooner says:

    Ramsey’s plan is brilliant for all populations.

    This plan works well for people who are intellectually overwhelmed with the idea of repairing their financial situation or unable to construct their own plan.

    This plan also works well for people who are able to use it as a platform from which to launch their plan, and smart enough to ‘personalize’ it, understanding the philosophy of this plan (and always remaining attentive of the concept)…even while not necessarily applying the algorythm exactly.

    One of the most important lessons is that of shaking off the peer-pressure practice of living in debt all the time…no matter how you do it. I went this route (painfully), about a decade before I ever heard of Ramsey, and until about a year ago, I thought I was a debtless freak who stood alone paying cash for my cars and refusing to use a credit card. Thank God for Dave.

  27. Mark says:

    @TV GIRL

    To calculate your effective interest rate on your loans, just multiply the interest rate by 1 minus your tax rate – for example – if you are in the 25% bracket you would multiply your interest rate by .75 (1-.25).

    So your loans would have an effective rate of 6.2% and 4.2% respectively. It might make sense to attack the higher loan since it is higher than most “safe” investments, however, the lower loan you could beat that with an online savings account/CD, so I would wait to pay that down until you have a comfortable savings level.


    That is why I said I “could” double that return with a higher risk investment, it doesn’t mean that I would or would feel comfortable doing that, although over the long-term I do feel that an 8% return is a reasonable assumption.

  28. Chef says:

    A good crossover point for loans is to look and see what rates are available on CDs. If your loan is higher than the going rate for long-term CDs – you have a guaranteed return that is not available to the average person. At least that’s how I think about it.

  29. Fantastic post! We were at the same spot…January 2005 and we’re still on step 2! God is good! Congrats on making it so far and changing your family tree for life!

  30. s says:

    @Mark, you are repeatedly forgetting to account for the tax on interest or investment income. It has been mentioned before, but I thought it needed reiteration.

    If you are comparing tax-deductible interest with taxable income, you can ignore the tax implications (assuming that regardless of you decision you could deduct the interest). You can’t adjust the interest on the debt for taxes, but ignore it on the income. Do both or neither.

    For “regular” debt, or if you don’t have deductions needed to bother with itemizing deductions, then it is crucial that you take into account the tax. 5% interest in a bank account end up being only 3.75% if you are in 25% tax bracket. This makes a difference for TV GIRLS’s debt. If her alternative is a 5.625% return (or less), which any bank account is, then she should definitely be paying it off.

  31. Mark says:


    You are absolutely right, I knew I was oversimplifying the situation somehow, thanks for pointing it out.

    However, if you are investing in a tax-deferred account (401k, IRA) then the logic would apply.

  32. MossySF says:

    The only concern I’d have with skipping #4 is losing the Roth IRA contributions. 10 years from now, you find you have a good amount to invest, you can’t go back and overcontribute for what you missed out on. So while making extra payments on a mortgage is fine, make sure you alway free up enough for Roth IRA contributions.

  33. Undertrader says:

    *Sigh*, everyone wants to get rich quick and that is not the way to get rich. The way to get rich is to get rid of your debt. All of your debt. Then you have 100% of your income to use in any way you like. Putting your money in a savings account, even at 5% is a horrible, horrible return. Once you include taxes on the gains, inflation, etc you return is nothing. You’re losing money.

    If you think you can beat your 8% loan, you’re kidding yourself. Sure, the average return in the market is 10% (my average return in the market over the past 6 years is 21%), but you aren’t factoring in RISK. There is TONS of risk in the stock market. It’s overpriced as it is and just waiting to fall. Investing in real estate 2 years ago would have netted you a huge loss at best, or a foreclosure at worst.

    I paid off my house. I could have continued to TRY to match my average return of 20%, which I do with my free cash, however, to risk my house to do that is insane and a horrible investment strategy, not to mention that I’m now investing my entire mortgage payment on a monthly basis for life. I’ll make more than enough money in the next 40 years.

    When doing these calculations, you need to account for taxes, inflation and risk, not to mention when you invest your money, a major, major majority of people choose the wrong investment or time getting into the investment wrong. Listen to Ramsey because he has it right.

    I keep seeing, “You can deduct the interest”, but that’s an insane argument because you are paying $10,000 to save $2,500. Simple math there.

    There is no such thing as good debt. Get a loan for your house, maybe for your education IF the job you are going to get is going to pay off the debt within 2 years, but bottom line is, if you can get yourself completely out of debt, including the house, it makes all of these 1-2% difference arguments a moot point because you will become a millionaire if you get out of debt and save your money wisely. The tortoise wins the race my friends.

    – Undertrader

  34. Peter says:

    One thing not discussed in the six points is the before you can really start any of them, you have to have a spending plan (aka budget) to track all your income and expenditures and see what’s bleeding the most out of your income. Then you have to pretty much have to stick to it. Without that, none of the steps really get you on the road to wealth.

  35. David says:

    If you are considering step 7 prior to paying off your mortgage, answer this question:

    Would you borrow against your house in order to start investing?

    Some people consider this a valid thing to do (the old ‘other people’s money’ concept). I personally would rather eliminate the risk and then move forward with full abandon on building wealth. Spin up some spreadsheets. You may find a small advantage to investing while still paying off debt…. it depends on the interest rates, taxes, and inflation. However, you are also taking on risk. For that very small difference, why take on the added risk? If you’re OK with this, more power to you. But its not for me.

    When I first evaluated Dave’s baby steps, I found all sorts of numeric holes in the method. However, the longer I’ve looked at them, the fewer changes I’d make. The method is sound when you take all factors into consideration.

  36. linder says:

    undertrader said it all. Pay down your debt!

  37. rolo4evr says:

    The Total Money Makeover is not presented as “gospel” and Dave DOES RECOMMEND veering off the order of steps in certain circumstances. One of the time he DOES RECOMMEND going out of order is when a person KNOWS their job is ending on X date. His advice is to drop Baby Step 2 AKA Debt Snowball and move to Baby Step 3 AKA Fully Funded Emergency Fund so that one has 6 months or more of expenses covered. Only after the storm has passed and income is once again being earned, do you restart your Baby Step 2. This is just one example of making the TMMO PERSONAL, as in personal finance. Listen to his radio program on the internet. He shares many instances of when the Baby Steps MUST be utilized OUT OF ORDER. It is not presented as gospel or unadaptable. The plan, IDEALLY, would be the steps in order, but even Dave knows that Murphy comes to call and personal finance is just that: PERSONAL.

  38. betty says:

    my favorite part of Dave’s plan is the “cash in envelopes” idea. Peace of mind from knowing the car insurance, the new roof, etc will be covered when the time comes is priceless. thanks Dave and thanks to the Simple Dollar!!

  39. Rusty says:

    I have to weigh in. No one ever considers total risk when deciding whether or not to invest or keep the mortgage (Assumption = $250K invested with a $250K Mortgage). Here are a few things to consider.

    1) Tax advantage of mortgage: If you are married filing jointly and make $100K/yr (100K @ 25% tax rate is $25K tax bill) If you have a $250K mortgage @ 6% with a monthly payment of approx $1500, Your yearly interest would be around $15K. If you itemize, your AGI (Ajusted Gross Income) would now be $85K ($85K @ 25% tax rate is $21,250). So, you would have paid the mortgage company $18K for the opportunity to save $3,750 in taxes. That’s pretty dumb.

    2) Capital Gains. If I invest @ the stock market average of 11.78% and have a 6% mortgage, I will net 5.78%. If I invested the mortgage of $250K @ 5.78%, I would earn $14,839.03. I would have to pay $2225.85 in capital gains. This would net me $12,613.18 reducing your effective rate to about 4.93% Not too bad really, but I’m not done yet.

    3) Inflation. The Long-term Ave is 3.42% per year. So let’s reduce our rate down to 2.36% (11.78% – 6% – 3.42%). Now we have made $5964.25. ($5069.61 after tax). Keep reading.

    Now let’s imagine that we were investing over 20yrs. Our effective rate after mortage interest, inflation and taxes is 2.01%. We would have earned $123,577.21 over 20 years, but If instead of investing we paid off the house today and began investing our payment ($1500) at %8.36 (11.78% – 3.42%), we would have made $564,122.39 in interest. Our total contributions would have been $360K and our capital gains taxes would be $84,618.36. We would net $479,504.03

    When you keep a mortgage, you split your earnings with the bank. Can you say stupid!!!

  40. Mel says:

    For Rusty’s comment… Everything you’ve stated and calculated is amazing. However, have you considered that people in Dave Ramsey’s Plan do not have $250k lying around to invest? After paying off debt, and saving 3-6 months for emergency funds they’ll have approximiately 4k-10K+ (depends on expenses and income). Real life, regular people.

  41. money market trader says:

    would be interesting to have this debate after the expectations have changed for income security as well as returns on investments. looks like the original post was done in oct 2007.

    fyi, as of apr 2009 i have opted to move beyond step 2 and keep my student loans because they are at 1.875%.

  42. deRuiter says:

    #6 Wendy has a fine grasp of things financially. There’s more to consider: If you’re paying 3% interest, you must earn an amount equal to 5% so that after the governments confiscate your money in taxes, YOU HAVE THE 3% LEFT. By prepaying on a mortgage or loan, you actually save (by not having to earn the money to pay the interest) almost double the interest rate you are paying. A house is also a money maker if you look at it that way. 1. You can run a couple of yard sales there every year. 2. You can rent out one or more rooms if things are tight financially. 3. You can rent the entire house and move in with friends or family to get over a rough patch. 4. You can rent out the garage for storage to earn extra cash. 5. You can prepay on the mortgage and shave off years from the mortgage and thousands of dollars from the interest. You may not WANT to do these things, but you CAN do them if you own a house. In today’s market, it’s hard to beat a 5% return on stocks, and impossible to get 5% interest unless you are investing with another Bernie Madoff. So paying off debt becomes more appealing because it would be difficult or impossible to make as much interest (ON WHICH YOU MUST PAY INCOME TAXES) as it would be to pay off the mortgage or student loans, and save all the pretax money you would otherwise have to earn to pay off the loans with after tax dollars.

  43. lvngwell says:

    I think the most important thing about Dave’s plan is that it gets people to take action and think about what is best for their situation. You can debate what to pay off when – but it is a personal decision – Dave is not going to show up at your house and put a gun to your head to force you to dump your stocks and pay off your house early. What he will do is get you to take a proactive look at the way you spend your money and how you handle your finances. There are things we can all agree on in Dave’s plan – credit card debt is bad, pay it off. Saving is good, investing is good, and budgets are good. If you act on only those few things you will get out of debt eventually. If you personalize the plan and get out of debt 6 months or a year later than you would have following Dave to the letter – well – it is YOUR 6 months or year to spend any way you like – right? But either way in the end – you will STILL be out of debt and financially independent!!

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