Total money makeover
Seven steps to financial freedom
Are you in need of a total money makeover? American financial guru and self-made millionaire Dave Ramsay has a seven-step process for you. These are explained in his book, The Total Money Makeover. Here, he advocates a specific process to become financially secure. Despite the book's “snake-oil” sounding title, the steps are excellent.
These seven steps aren’t without controversy, so to help you on your way, we’ve taken the liberty of adding our own comments to some of Dave Ramsay’s steps.
By following the seven steps in sequence — not moving on to the next until the current step is complete — you will gradually progress from debt to wealth. Let’s take a closer look.
Step one: Starter emergency fund
Before you do anything else, Ramsay suggests saving $1,000 cash as a starter emergency fund. This money is to be used only for emergencies: car repairs, unexpected dental bills, and so on. This cushion of cash will ensure that life’s mishaps won’t force you deeper into debt, and you’ll be able to recover more quickly.
Step two: The debt snowball
Once you’ve built a small emergency account, it’s time to tackle any bad debts. Ramsay is a keen advocate of the debt snowball method. Here’s how it works:
- List your non-mortgage debts from lowest balance to highest balance. This could include car repayments, or a credit card.
- Pay the minimum payment on all debts except the one with the smallest balance.
- Throw every cent you can find at the smallest debt.
- When that debt is gone, do not alter the monthly amount used to pay debts, but pay all you can toward the debt with the next-lowest balance.
Milestone Direct comment: The debt snowball is the most controversial part of Ramsey’s plan, and is one of the two methods to deal with bad debts. Instead of the debt snowball you can use the “debt avalanche” method, where you pay extra money toward the one debt with the highest interest rate.
Both methods require that you list out your debts and make minimum payments on all but one debt, but that’s where the methods vary.
The logic behind the debt snowball method is based on gaining the mental advantage of having less debts to repay, as Ramsey explains: “The reason we list smallest to largest is to have some quick wins”. Naturally, you can choose whatever method you prefer based on what might work best for you.
Step three: Finish the emergency fund
Your $1,000 emergency fund was only a start — after you’ve eliminated your non-mortgage debt, it’s time for you to grow a better backstop. Ramsey’s advice is standard on this point: accumulate three to six months of living expenses. For most people, that’s $10,000 or so.
The easiest way to do this is to simply take the money you were applying to your debt snowball and convert it into a savings snowball. If you were paying $500 each month toward debt, now put that regular sum into a high-yield savings account.
Step four: Invest 15% of your annual income towards retirement
While you’re completing the first three steps (especially the first two), Ramsey recommends suspending all investment activity, which even includes into the US equivalent to KiwiSaver. He saves investing for step four, once good habits have been established. According to Ramsey, it’s true that you’ll give up a few years of compound returns in your retirement accounts, but that’s okay in the long run. By following the first three steps, you will have developed smart money habits and a strong saving ethic, so that it won’t take much effort to catch up.
Now that you’ve paid off your debt and saved for emergencies, Ramsey says to invest 15% of your income into managed funds. He recommends diversifying this particularly well, first into the equivalent of a KiwiSaver Scheme to maximise the benefits available, then put the rest of the 15% wherever it makes the most sense.
Milestone Direct comment: Ceasing KiwiSaver contributions while you repay debt and build up an emergency fund risks missing out on some of the great benefits of KiwiSaver (such as matching employer contributions) and risks that you’ll have lost momentum and won’t restart contributions again. This means it’s unlikely that “one size fits all” in this area.
Step five: Save for your kid’s studies
Once you’ve begun saving for your retirement, you can turn your attention towards your children. Ramsey writes, “Saving for college ensures that a legacy of debt is not handed down your family tree.”
Ramsey also emphasizes that kids can work their way through college to minimise student loans they need to take out.
Milestone Direct comment: With New Zealand’s heavily-subsidised university education system, most Kiwi families might not see this as the top priority that Ramsey does – and instead might want to work on step number six instead!
Step six: Pay off your home mortgage
Once you’ve taken care of everything else, it’s time for a final, giant step. Ramsey advocates repaying your mortgage. He’s aware of the objections, such as this possibly not making the most financial sense, but he believes it’s still a smart step to take.
Step seven: Build wealth
If you’ve done all these things — eliminated debt, built emergency savings, invested 15% of your income, and paid off your mortgage — you can begin to build some serious wealth, says Ramsey. By following the first few baby steps, you’re far ahead of most people. But with the final step, you can enjoy the fruits of your labours.
This might include giving to charity, retiring early, and having plenty of fun. If you want to buy a boat and you’ve completed the “baby steps”, then buy a boat. Just don’t go into debt to do it.
The bottom line
Let’s recap Dave Ramsay’s seven steps to totally makeover your money:
- Starter emergency fund
- Use the debt snowball
- Finish the emergency fund
- Invest 15% for your retirement
- Save for college
- Repay the home mortgage
- Build wealth