By Maggie Ellis, guest writer
I know many people who are followers of Dave Ramsey’s financial advice. Since the economy has tanked, it seems like I’m seeing even more people joining the Dave bandwagon, looking for a way out of the financial messes that they have gotten themselves into. His “Total Money Makeover” and the associated baby steps can be a decent starting point for those who have no idea where to start or who have never tackled financial topics before. It’s simple and fairly easy to follow advice. It may be a bit too simplistic and “one size fits all,” but it’s not a bad starting point, generally speaking.
However, lately I’ve found myself questioning whether or not his advice is still valid given the current economic climate. In a down economy, most of us want protection and preservation. We play defense to save what we have. Dave’s advice is more offense-oriented, requiring you to aggressively pay down debt as fast as possible and get on to wealth building. Not a bad idea when jobs are plentiful and salaries keep growing. When money is everywhere, it’s easy to dedicate a lot of it to debt repayment and investing. But when the economy is bad and the threat of job losses and declining investments make us want to hole up and hide, other approaches might be saner.
Does the current economic situation require a reordering or rethinking of Dave’s advice? With so many people looking to clean up their financial houses, is Dave still the best place to start? Let me take a look at each of his baby steps and see if his advice still holds in a down economy.
Save up $1,000 to start an emergency fund
I have a couple of problems with this bit of advice. First of all, for most emergencies, $1,000 isn’t nearly enough, in good times or in bad. It won’t pay for a new roof or a new heating system. It will only pay for a bare bones appliance replacement. If something big goes wrong with your car, $1,000 won’t cover it. $1,000 will barely scratch the surface of most emergency needs. You need a much bigger emergency fund than this and in a bad economy with prices rising daily, you need it sooner rather than later.
That brings me to my second problem with this bit of advice. Dave advocates saving up the bigger nest egg in Step 3, after all your debt is paid off. However, in a bad economy, you’d better be saving all you can as fast as you can. If you get laid off or put on a reduced schedule, that $1,000 will be gone in a very short time and you’ll be back to living on credit. In a good economy when jobs are secure, you might be able to get by on that $1,000 emergency fund until the debt is paid off. If you want to be secure in a down economy you’d better have that larger emergency fund (or be actively building it) against the day that your job is eliminated.
Pay off all debt using the snowball method
Paying off debt is good. I won’t disagree with this. And I don’t disapprove of the snowball method (in which you pay off the smallest debt first and then add that payment to the payment you’re making on the next largest debt and so on until all debt is paid). However, in a down economy you need to evaluate whether aggressively paying down debt this early in the plan is the best thing for you. (Obviously, you don’t want to be incurring any new debt in a down economy if you can avoid it.) If you are facing the prospect of a job loss or pay cut, you might be better served by continuing to pay the minimums on your debt and funneling all your extra cash to your emergency fund. Being debt free is nice, but not if it means that you have no money in the event of a lay off. If that happens, you’ll be racking that debt back up in no time. If you still have debt but have plenty of cash on hand, you can at least keep the debt load from growing while you’re unemployed. When things turn better and your job situation is more secure you can turn your attention to this step and pay down your debt. But in the meantime, stash all the cash you can in order to protect yourself.
Save up 3 to 6 months of living expenses
In a down economy, I don’t think this should be Step 3 on Dave’s plan. It should be step one. As I noted before, you need to have cash on hand in a down economy to protect you in the event of a layoff. Three to six months is probably too little. Jobs take longer to find in a bad economy because many people are competing for a small number of positions. I’d aim for six to eight months of living expenses. The more you can get, the better. Start saving this larger nest egg as soon as possible and keep adding to it until you have enough to cover six to eight months of living expenses. This should be your priority in a bad economy.
Invest 15% of household income into Roth IRAs and pre-tax retirement accounts
Bad economy or good, I would advise that you contribute at least something to your retirement portfolio at all times. The good news is that in a down market, every bit that you can plow into a 401K or mutual fund IRA is buying you more shares at a deeply discounted rate. You may not reap the benefits immediately but when the market rallies, you’re primed to take advantage. If you wait until all debt is paid off (which for some could be a long time) and you can contribute Dave’s full 15%, you miss out on the fire sale and all that compound interest you could earn over time. You also miss out on any free money that your employer might match with yours. You might be drawing on your retirement money for as long as thirty years. You need all the time you can get to save up enough to cover you if you live a long life. If you wait until all the debt is paid off, you are cutting into your prime savings time and missing out on some bargains.
If money is tight and you can’t do two things at once, save up your larger emergency fund first to take care of any immediate crises and then divide any extra between a retirement plan and your debt repayment. Once your emergency fund is big enough, the debt is paid, the economy is better and you are in a secure financial place, up your contributions until you get to 15%.
Save for your kid’s college educations
In a down economy, I would eliminate this step entirely unless you are very well off and don’t have any other needs for the money. It’s great to be able to help your kids pay for school, but not if it comes at the expense of your own needs. I would continue to add to the emergency funds and retirement accounts and pay off my home before setting aside money for college. Your kids can get scholarships and aid for school (and some might not even go at all), but you have to protect yourself first.
Pay off your home early
A noble goal and one that will free you from a mortgage payment. I would take care of this step before saving for the kid’s college educations. Without a mortgage payment, you’ll be able to save for college that much faster and your own interests will be protected. In a down economy, being free of a mortgage is a great thing and one that frees you to take lesser paying jobs or work less in the event of a layoff.
Invest in mutual funds and real estate to build wealth and give
The mutual funds part I agree with, although you need to know what you’re doing or have a trusted financial advisor to help you pick some good ones. You don’t want to invest in junk. Even in this economy there are some good mutual funds out there, but you’ll probably need direction to find them. If you get into some good funds and have a substantial amount invested, you can live off of the interest, let the principal continue to build wealth for you, and reduce the amount you need to work.
Real estate, however? Correct me if I’m wrong, but isn’t over-speculation in real estate part of what got us into this economic mess in the first place? Isn’t that, at least in part, what drove prices sky high and then caused the bubble to explode? I don’t deny that owning some real estate can be a decent investment and right now it is a buyer’s market. However, you have to know what you’re doing. Simply “investing in real estate” won’t cut it. Are you going to rent the property? Can you handle the landlord aspects? Can you comfortably carry the mortgage(s) until the rental pays for itself? Are you going to sell it? (Good luck in this market.) Do you understand pricing enough to know when you’re paying too much or when something is a deal? Are you going to be a “flipper?” (I hope not because a lot of those people got burned in the recent bubble bust.) Dave says to invest in real estate on the theory that real estate always goes up in value, but we’ve now learned that this isn’t always true. You can lose your shirt in real estate, particularly if you don’t know what you’re doing (and even if you do). I would seriously question this piece of advice before deciding to put much of my nest egg into real estate.
The giving part of this step is a good one for those who have reached this point and have the means. In a down economy many people stop giving in order to protect their own finances. However you got your wealth, whether it was by following Dave or hitting it lucky in the lottery, please do give to help others.
The idea that you should do one step at a time and not do things in conjunction with one another is where I think Dave falters most in a down economy. We’re trying to deal with a lot of things at once and some multi-tasking is required in order to make the most of our money and time. Particularly if you’re working against a ticking clock where a job loss is imminent, you may need to allocate your money to several steps at once to prepare for unemployment rather than plodding along through one step at a time. I would reorder/restate Dave’s steps this way in a down economy:
1. Save up six to eight months of living expenses: Combine Dave’s steps one and three together and save up as much cash as you can to cover yourself in the event of a job loss or cutback.
2. Invest at least something into your retirement plan at all times to take advantage of compound interest and time: Instead of waiting until all debt is paid off, go ahead and work on your retirement portfolio. You’ll need all the time you can get to save enough so start now. Make sure to contribute enough to get any employer matching funds.
3. Work on debt repayment, but only when your immediate security is taken care of: Pay only the minimums until your emergency fund is large enough to see you through a long layoff. When you reach that point, divide the extra money between your debt and your retirement, paying as much on the debt as you can while still building that retirement plan.
4. When the debt is gone, up your retirement contributions to the full 15%.
5. Pay off your home early: If you have your emergency fund, no other debt, and are fully funding your retirement, go ahead and work on paying off your home. At least if you get the house paid off it will be one less thing to worry about the next time the economy tanks. You won’t have that mortgage payment to deal with.
6. Invest in mutual funds (or another investment vehicle that you are comfortable with) to build wealth and give: Your goal is to create the kind of wealth that can sustain you on the interest alone. With the rest you can give, save, or move on to step seven and provide for your kid’s education.
7. Save for your kids’ college educations: This would be my last step, once all of my needs are taken care of and my future is provided for. Once you’ve created wealth in step six, you’ll be well able to provide for your kid’s educations. But if you don’t reach this step or are still working on it come college time, your kids can find ways to provide for their own educations. Your needs have to come first.
While some of Dave’s advice remains valid in a down economy, some of it bears closer inspection before you jump headlong into his program. If you go into his plan thinking it will save you and that there can be nothing wrong with his advice, you may end up surprised. A lot of the old rules don’t apply right now and you have to figure out what is valid for your situation and what is not. You may need to tackle several steps at once or reorder them to get the best results and protect yourself from a topsy turvy economy.
The bottom line is that, while some advice may remain valid no matter the economic circumstances, you should always evaluate your own circumstances and needs in the current economic context and not do something just because a financial guru (be it Dave, me, or anyone else) tells you to.