If you’ve been around the personal finance world long enough you would have inevitably bumped into an American named Dave Ramsey.
He currently hosts Dave Ramsey Show on YouTube and he teaches people how to become wealthy by saving, getting out of debt and investing.
He’s been doing this for over 25 years and has garnered quite a following. If you’ve had the opportunity to listen to his popular podcast show (or watched from YouTube) then you would have heard him mention the seven baby steps.
What are Dave Ramsey’s Baby Steps?
As the name suggests the baby steps are small changes you make in your lifestyle and when done in the correct succession help to achieve wealth.
Here are the 7 Baby Steps:
Baby Step 0 – Get Current On All Your Bills
Okay, so this isn’t really part of the Baby Steps, but it’s worth noting that before you embark on the Baby Step journey that you’re not behind on payments for all your bills.
Get current on all your food, shelter (rent, rates), transport and utility bills (lights, water, electricity). If you’re struggling to achieve the first foundational step then you need to analyse why you can’t current on your basic living costs.
Are you spending too much on food? Can you find cheaper rent? Can you find cheaper utilities? Or is it an issue with income – do you need to get out there and find more jobs?
Once you’re current on all your bills you now should have the capacity to save and to start working on reducing your debts.
Baby Step 1 – Save $1,000 Emergency Fund
The first official baby step is to save for an emergency fund of $1,000. It’s not meant to be a true emergency fund in the sense of this amount will cover all emergencies that will come up in life, but it’s enough to provide a little barrier, and small enough to goad you into getting the next baby step done.
If you’re struggling to achieve the first baby step you might want to look at how you’re spending your money – are you doing a budget? If not, and you’re here, there should be no excuse in you using our free Cash Flow Forecasting Google Sheet.
If you’ve monitored your expenses, and done a budget, and still find you are struggling to eke out enough to save for an emergency fund you might want to consider selling some stuff. Just look around and see what you can sell, and list it on eBay or GumTree (free!).
Once you have $1,000 in your emergency fund then you can with intensity move on to the next baby step…
Baby Step 2 – Pay Off All Consumer Debt
This next step can take the longest depending upon the types of debt you’ve acquired over the years.
Debts listed in this category would include:
- Car debt
- Credit card debt
- Student loans (HECS, HELP)
- Other debts (Centrelink, furniture, medical, etc.)
Everything except for the mortgage.
Now the way you need to tackle your mountain of debt is by utilising the debt snowball method.
What’s The Debt Snowball Method?
The debt snowball method is a behavioural technique to get you motivated in paying off your debt faster. It’s been argued many times on the Dave Ramsey Show that mathematically paying debt off with the highest interest rate would be cheaper, however, this assumes you’re paying the debt off for both methods in the same way.
What tends to happen though is that once we begin to pay off our debts in the order of smallest to largest, we begin witnessing achievement. It’s through achievement that builds momentum in paying off our loans.
So pay off all your consumer and student debt, list them all one by one in order of the balance payable for each loan. Then start throwing any spare cash from your budget straight into these debts.
But what if you’ve been to university and have a HECS/HELP debt?
How Can You Pay HECS/HELP Debt Off Quicker?
If you go to university here in Australia you have the option of undertaking your studies and having the Commonwealth Government pay for your courses. Then once you begin working and earning more than $46,620 (as of 2020-21 financial year) you will have amounts withheld from your pay by your employer that is remitted to the ATO in making payments against your student loan.
As your salary continues to increase so too does the amount withheld by your employer. For example, if you earn $136,740 or more then 10% of your earnings are remitted to the ATO against your Commonwealth student debt.
But can you pay more?
Yes, you can make what is called voluntary payments by opting to pay more against your student loan. You could opt to salary sacrifice a part of your gross salary (being mindful that FBT may need to be withheld depending on your employer), otherwise the payment options available are found on the ATO website here.
If you do plan on making extra repayments against your student loan, ensure you make any ad-hoc payments before the end of the financial year.
Once you’ve finally paid off all your student loans and consumer debt, you can then skip on to the next baby step:
Baby Step 3 – Fully Funded Emergency Account
This is where you now build up your emergency fund of 3-6 months worth of expenses.
So what is your fully funded emergency account size?
It depends upon the level of risk of the income being received. Here are some factors you’ll need to consider when determining whether you should aim for a 3 month emergency fund, or 6 month:
- Do both spouses work? If yes, 3 months, otherwise if only one spouse is working aim for 6 months.
- Is the income source variable (i.e. commissions)? If yes, 6 months. If not, 3 months.
- Is there a likelihood of retrenchment or redundancy coming? If yes, 6 months, otherwise 3 months.
- Would it be difficult to be re-hired if your job was lost in the current job climate? If yes, 6 months. No, 3 months.
Depending upon your answers to those questions you should get an idea of where on the spectrum of 3 to 6 months you’d lay, and most fully funded emergency accounts range from $15,000 to $30,000.
Once you’ve got your fully funded emergency account you can now take your foot off the pedal in being gazelle intense and the next three baby steps are done together.
Baby Step 4 – 15% Of Gross Income Into Retirement
Thankfully here in Australia we have the Superannuation Guarantee Charge Act 1992 which means employers pay 9.5% per annum (for the 2020-21 financial year) into our retirement account. This would mean we would salary sacrifice the remaining 5.5% (15% – 9.5%) into our superannuation account.
Get in touch with your HR or Payroll department to how you can automatically have the 5.5% sacrificed into your super account.
With legislative changes to increase super to 12% by 2025 this could mean in the future we’d only need to salary sacrifice an additional 3% into our super.
Keep an eye on when the Super Guarantee Contribution (SGC) rate does change, and when it does at the start of a new financial year request from your HR or Payroll department to modify your salary sacrificed amount.
Watch Your Concessional Contributions Cap
There is one caveat for salary sacrificing the additional amount into your super account, watch your concessional contributions cap (currently $25,000 for 2020-21).
The concessional contributions cap is calculated by adding up your employer’s Super Guarantee Contributions plus any salary sacrificed super and any non-deductible super contributions.
In essence, if you only salary sacrifice super and rely on your employer contributing their 9.5% (currently) into your super account then it would mean once you are earning more than $166,666 (the concessional contributions limit divided by 15%) that you’ll need to think of other ways to invest 15% of your gross income.
You may want to chat with your super fund about options they may have available, but some other ways you could look at investing your income to reach the 15% mark if you’re salary is above $166,666 include:
- Contributing to your spouse’s superannuation account (post-tax).
- Investing in other mutual funds (perhaps chat with your bank about options).
- Invest in ETF’s, or with companies that automatically invest in ETF’s on your behalf (such as Raiz Invest).
The important aspect with this step is not to go beyond investing 15% of your gross earnings. Some people can over the top with this baby step as they think by investing most of their money into investing it will speed up the wealth goal.
Stick to the plan and put any excess cash you have into baby step 6, but before we get there what is baby step 5?
Baby Step 5 – Save For Kids College/University
This is probably the most conversational baby step for families in Australia. We’re thankfully quite blessed here in Australia with our higher education and don’t nearly have all the problems America experiences with their education costs.
But as we saw previously in Baby Step 2 if your child elects to undertake study at university or college they will be able to have the government pay for their studies and then through their salary have amounts withheld to pay this debt off.
Depending upon how large the debt is it could take several years for your child to pay this off, so should you lend a helping hand by saving up for their college fees and paying it forward when they enrol?
This is a decision that every family would need to make in its own right, and out of all the baby steps this one is probably the least impactful on your own personal wealth journey, but could very well be the most impactful for your children in their 20-30’s.
Personally I did have some help from my parents in having my HELP debt reduced, but it was not fully paid. I’m very grateful for my parents’ help in this area, and some of you may find yourself in a similar boat – you can only provide limited help in this area.
Some issues to think about in your discussion with your spouse would be:
- If we pay does that mean we choose what our children study and where they study?
- If we pay and they fail do we keep paying?
- Should we pay their debt once they’ve successfully graduated? Should it be a surprise, or do we let them know before they start and choose their course of study? Would knowing beforehand help them to choose a better course/college?
As you can see there are some deep discussion points to consider here and it can be a tough one to navigate. Whatever your decision make sure you and your spouse are both agreed on whatever it is you’d like to do to help your kids out with their education.
But what if you don’t have kids, or aren’t likely to have children, or your children have flown the nest?
You can skip this baby step and move on to the next:
Baby Step 6 – Pay Off Mortgage Early
Dave Ramsey instructs home owners to get a 15-year fixed mortgage on their place of residence. No more than a third of your take-home pay should be used to service the repayments of the mortgage.
In other words if one-third of your take home pay is less than your mortgage repayment then you would not purchase that home.
Regardless of what your mortgage happens to be, at the parallel baby steps of 4, 5 and this one, any extra money is thrown into the mortgage (rather than thrown into investments).
By throwing everything into the mortgage it allows us to free up our biggest wealth building tool which is our income.
Once you’ve then paid off your home loan, you have fully funded your child’s higher education costs then you can advance to the prized final baby step:
Baby Step 7 – Live & Give Generously
Now that you’re purposely living on a budget, are completely debt free, have a fully funded emergency account, have your children’s education taken care of you can decide on how you’d like to enjoy the free cash flow of your hard earned efforts.
You can look at increasing your investment allocation, and increasing your giving amounts – and you can go and experience more of life without the financial stress that comes with being in debt.
And from here on out you’ll experience the freedom being out of debt brings and the power of flexibility to allocate your excess funds wherever you wish.
If you want to renovate or purchase a new home, or investment property, or a new car, and you don’t have the cash for it you’ll now know it’s better just to knuckle down hard for it (just as you did through baby steps 1 and 3) and you’ll save up for it.
From this great vantage point you don’t want to go back into the “joys” of debt repayment and paying somebody interest as well as fees for the privilege of not being patient enough to save up then buy.
As you can see from the above the Dave Ramsey Baby Steps can apply to Australians. At the end of the Baby Step process you have transformed your way of life and thinking when it comes to financial matters. The Baby Step process is not meant to be an easy quick fix, instead it’s all about knuckling down and getting the job done.