Thursday, November 09, 2006

Questioning Dave Ramsey's Baby Steps 2 and 3...

Regarding Dave Ramsey's baby step 2, yes the math doesn't make sense. But the idea isn't to quickly pay off debt, it's to change you behavior and learn to not use credit cards and more importantly live below your means. Changing your behavior is the toughest part of financial responsibility.

Now first my issue with stopping retirement contribution. Yes you do need to be focused, however if you are going to be on BS2 for longer than 24 months then even DR says you probably need a larger than $1000 baby EF and you shouldn't stop retirement contributions at least up to the company match in the 401k. This is because Murphy's Law is more likely to occur the longer you go without a Emergency Fund. Now I think that passing over the 100% match from the company in the 401k is a bad idea no matter how long you are in BS2. It's a guaranteed 100% return on investment, so I think it's worth delaying BS2 by one month or two to get it. But this is personal finance and it's up to you.

My bigger issue with BS3, is that DR doesn't give enough attention to what a emergency fund should encompass. Some people feel it encompasses anything like car replacement, home maintanence, etc. I however feel that the EF should only be for death, surgery, and job loss. Everything else should be covered by it's own sink or replacement fund. What does this mean?

This means that you should get 3 months of expenses in place, then start sink fund, then go back and finish up your EF to 6 months. Now what are sinking fund? Stuff like car repairs, vacations, property taxes, car insurance, home maintanence, gifts, christmas, birthdays, furniture, pet fund (if pet is old), stuff that can go wrong and yet aren't sure how much but you want to be prepared. I don't think a car breaking down is an emergency, instead you knew your car is old and either you are saving to replace it or you are saving to repair it. I think you should determine how much you need to replace it (because no car lasts forever), then save that monthly. Same thing with a house, you should be saving 1% of your home value for annual maintanence.

But people really get excited with retirement, and ESPECIALLY paying off the house they forget about proper care and maintanence. Sure it's great, but what if when you are rushing through some steps you car breaks? Do you really want to forever drive a hoopty? I don't think DR puts enough emphasis on how and EF is for true emergencies and everything else needs to be budgeted for.

My final issue with steps 2 and 3, is that I think buying a home should come after step 4. You should fund retirement and get an idea of what it feels like to minimally save 15% before you commit to a mortgage. That way you don't get into more debt than you can handle. I see some people paying off debt, buying a home, yet struggling with 15% retirement. It's likely they didn't realize how tough it can be. However I do agree with DR, that it's great to buy a home with 20% down to avoid PMI, and you should try to stay within the 25% PITI guidelines. Just because the bank offers you a loan, doesn't mean you can really afford it.

As far as steps 4, 5, and 6, I'll discuss that in depth tomorrow.

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