When Janice and I became gazelle intense about getting out of debt, we did so hook, line and sinker. Once we paid our credit cards off, we either quit using them or cancelled them. Over the years, I have sporadically checked my credit report, but had never become curious enough to obtain my official credit score.

However, because I have often heard Dave Ramsey touting his zero FICO score, and because it has been several years since I have used any credit of any kind, my curiosity finally got the best of me.  I, of course, took Dave’s claim with a grain of salt. After all, isn’t the minimum FICO score anyone can get something like 300? Still, I began to wonder: is my lack of any active credit hurting my score? If so, how much?

First: My Credit Report

Before giving you the details of my credit report, allow me to make a recommendation for those of you who will be checking your own credit reports: Save it as a pdf file. This is much easier to navigate than the multi-page printout I made last time. If, after you save the pdf file, you still want a printout, go for it.

So — here is the credit report info:

• I have a credit history of 21 years and 9 months.

• I have a total of one open account.

• My most recent activity for that account is 01/2005.

• I have a closed mortgage account because I made my last payment on 08/2004.

• I also have 8 revolving accounts which are all “Paid and Closed”, some with the comment “account closed due to inactivity.”

Now: My Credit Score

With only one open line of credit, and zero activity in six years and eight months, what is my credit score?

Drum roll please:   801.

But wait! This isn’t a FICO score. It is something called a VantageScore Report (from Experian). “What is going on?” Evidently, both Experian and Transunion are now issuing VantageScores instead of FICO scores. Who knew? Well, actually, anyone who has recently checked his credit score.

What does VantageScore of 801 mean?

According to the report that was included with the score, I am rated a “B”. My credit category is Prime Plus (but not Super Prime) and I rank higher than 61.64% of U. S. consumers. I could, according to this report, improve my score by having “more open, recently reported accounts as part of my credit history.” In addition, “having open, recently reported bankcard accounts as part of my credit history can have a positive impact on my credit score.”

How does VantageScore compare with FICO?

This is a very pertinent question because (according to my understanding),  Experian gives consumers the VantageScore number while giving potential lenders the FICO number. Not that I plan to borrow any money, but wouldn’t it be nice for consumers to see the same number that the lender is looking at? Because the top VantageScore is 990 while the top FICO is 850, I suppose I could estimate my FICO score by taking 86% (850/990) of my 801 score, which would give me a pro-rated FICO score of 688. For sake of comparison, I tried the FICO Score Estimator from BankRate.com. After answering 10 simple questions, I learned that my estimated FICO score is 725 – 775.   Hmmm.

Am I going to work toward improving my score?

Naw. To do so would mean either borrowing money or using a credit card, and I am just too content (and hard headed) to change how I do things. My wife and I love our cash envelope system; we don’t like credit cards (although we each have a debit card) and we disdain debt of any kind, so we will keep on doing what we have been doing. I know: my credit score could eventually cause a hike in my auto insurance premiums, but I have been monitoring those rates for some time and have seen no obvious jumps.

By the way, I would like to point out to my credit card user friends that I never said a single word in this post which remotely implies that I think you should do anything differently. Personal finance is personal, and if you do well by using your credit cards, I applaud you.

They just aren’t for me.

Readers: how often do you check your credit report?  Your credit score?

If you follow Dave Ramsey, you are aware that your very first priority is to establish a $1,000 emergency fund for those unexpected life events.   The point of this “Baby Step One” emergency fund is to provide you a buffer or fall back while you’re paying down debt with “gazelle intensity”.

But once you have your emergency fund, the question that begs to be answered is: What qualifies as an emergency?

Before you invade your emergency fund, be certain that you can clearly answer this question.  These five tips will help:

1. Is there any slack in the budget?

Is it reasonable to adjust a few of your budgeted categories — or even put a few on freeze — as you save up to cover the unexpected expense?  If so, you’ve turned your emergency into a budgeted category – at least for the time being.

2. Can it wait?

I know some things which seem like emergencies are actually only  inconvenient setbacks.  Are you needing a new TV, computer, or phone?  Will your old phone hold you off for a while?  I just spoke with a lady whose response to a computer crash was to charge $1,800 to get a new mac.  That decision added up to 1/3 of the consumer debt she held and it just added to the mess of debt.

3. How serious is it?

This is where it can be a little tough to decide if it really is an emergency.  Ultimately you’ll need to use your discretion and you might benefit from asking someone’s opinion.

In my opinion…

• Broken bone…emergency
• Sore back (paying for a massage)…nope
• Front door broke….yes, emergency
• Couch cushion ripped…I don’t think so

4. Do you have a plan to replenish it?

If you absolutely have to use the emergency fund, don’t get upset.  (It’s there for emergencies, right?) Your goal should be to replenish it as quickly as possible.  How you do it will involve some creativity – side jobs, budget category freezes, and garage sales are just a few ideas of how to rebuild that fund.

5. How can you avoid it in the future?

This final question is just as important as the first.  If you’ve built up your emergency fund and don’t want to experience the pain of dipping into it again, try to plan for the unexpected.  If you’re able to set aside funds into a separate emergency fund for auto, home, or health expenses, go for it!

Everyone’s financial situation is different and emergencies won’t be the same for everyone.  If there’s one thing that is the same, it’s that taking the time to ask these questions will help you to think through all of your options before you make the decision to touch your emergency fund.

Have you ever had to dip into your emergency fund?  What was it for?

Tim is a personal finance writer at Faith and Finance a Christian financial help blog that provides financial insights for individuals, businesses, and churches. Outside of finance, Tim enjoys spending time with his wife, playing the saxophone, reading economics books, and a good game of RISK or Catan. Find him on Twitter and Facebook and subscribe to the Faith and Finance RSS feed.

Proverbs 24:27 “First plant your fields; then build your barn.”

What does this verse mean?

When I first read this verse, I didn’t get it. Understand that I am not a farmer, so I didn’t see what difference it would make whether one planted first or built his barn first.  If fact, it seemed more logical to build the barn before planting so that one would have a place to store the grain when it was harvested.

However, upon further study, I learned that the writer was saying that, if planting time is now, don’t allow yourself to be sidelined by other activities, even something as important as building a barn.  Why?  Because, by the time Mr. Farmer got his barn built, it would probably be too late in the season to plant.  By doing things in the wrong order, our farmer friend would have lost a year’s crop and therefore have no need for that new barn.  Bad idea.

Good lesson:  “Do things in the right order”.

Financial application

What are your financial goals?  Get out of debt?  Great!  Invest for retirement?  Of course!  Save for emergencies?  Absolutely!  Plan for your childrens’ college?  Definitely!   Now…which will you do first?  “But Joe, I just figured I would do all of them“.

Bad plan.  If you try to do everything at once, you will spread yourself so thin that you won’t get any of them done.  Like the farmer in our Proverb, you need to prioritize and therefore be able to focus on one goal at a time.  In other words, do things in the right order.

Dave Ramsey’s Baby Steps

Dave Ramsey’s Baby Steps are formulated to give a logical sequence for accomplishing your financial goals.  I have written posts on each, so feel free to click any step for more details.   They are:

1. $1,000 “Baby” Emergency Fund
2. Debt Snowball
3. Fully Funded Emergency Fund
4. Invest for Retirement
5. Invest for Children’s College.
6. Pay off House Early.
7. Build Wealth and be Very Generous.

There is a reason for doing these steps in the order they are listed. For example, if you begin your debt snowball (step 2) before you build that baby emergency fund (step 1), every unexpected event will become an emergency which you pay for with your credit card.  Because creating debt while getting out of debt is counter productive and depressing, step 1 comes before step 2.

If you pay off your house (step 6) before building a fully funded emergency fund (step 3), and then lose your job, you will need liquid assets to buy groceries and pay your utility bill. Your paid for house wouldn’t do that; therefore step 3 comes before step 6.

Retirement investing (step 4) should be done before investing for children’s college (step 5).  Why?  Because children have many options for funding their college, but you only get one shot at retirement — it will be too late for a do-over once you reach retirement age.

I think you get the point. There is a logical reason for the order of each of these steps. The writer of Proverbs may not have known the Baby Steps as we know them today, but he understood the concept of doing things in the right order. I hope we can learn that same lesson.

Readers: Have you used Dave Ramsey’s Baby Steps?  How did doing one thing at a time, in this order, help?  Have you changed the order to fit your circumstances?  How and why?

You have seen those percentage budget plans which deftly tell you what percentage of your budget you should spend on which categories.  Yes, they are a good guide, but you need to beware: giving too much credence to those percentages could get you in trouble.

For example, the following percentages are recommended in Dave Ramsey’s Financial Peace University book:

Why these percentages could be misleading:

• Don’t fit high or low incomes.

Dave Ramsey rightfully points out that these are only recommended percentages and that if you have an unusually high or low income, they could change dramatically. For example, a couple who earns $20,000 annually will probably need more than 15% ($250 a month) for food while a couple who earns $200,000 will spend much less than 10% ($1667 a month) for food.

• May encourage auto-piloting.

It would be an easy thing to make budgetary decisions based on these percentages instead of your own life and goals. Personal finance is intended to be personal, meaning you need to carefully think through all of your income and all of your outgo, and make it fit what YOU want instead of what some recommended percentages say.

• Could detract from following through with your own goals.

Do you know your short term financial goals? Your long term goals? If not, why not? Your finances are not simply dollar amounts; they represent your value system. When Bob at Christian PF writes My Strategy for Giving Away Millions, he is planning his money (budget) based on his goals, not vice versa.

• Might be a nerd trap.

Some people (nerds…raise your hands) love numbers to the exclusion of what the numbers represent. One can have a perfectly balanced budget on a perfectly balanced spreadsheet with perfectly proportioned recommended spending, but if those numbers don’t translate to real life, they are only an exercise in math…and frustration.

• Could be a license for spending more than you should.

If you have debt that is weighting you down, a percentage budget might give you excuses for spending money on such things as car payments and recreation instead of funneling that money into an accelerated debt reduction plan. Again: your budget needs to reflect your goals, not a formula.

How percentage budgets can help:

• Prevent overspending on big ticket items.

Many people could have avoided real estate catastrophes if they had only limited their house payments to 25-30% of the income instead of stretching every penny in order to make their house payments. In the same way, total car payments of not more than 10-15% can give some sanity to those who think they need two or three new cars.

Concluding thoughts

Percentage budgets can be helpful guidelines, especially to avoid overspending on big ticket items, but remember: they are merely recommendations. Because budgets represent your goals and your values, start by clearing establishing your financial goals and then tailoring your budget to fulfill those goals.

Then, and only then, will your money truly match your life.

In your budget, how much importance do you give to “recommended percentages”?  When do these percentages help?  When have they been a hindrance?

photo credit: TheTruthAbout…

Do people really spend more with credit cards than with cash? This topic has been beaten until blue and there seems to be no documented study which proves one way or another. Yes, many of us have heard of the Dunn and Bradstreet study (oft quoted by Dave Ramsey) that indicates people spend 12-18% more when using credit cards, but evidently, according to Money Myths and the Importance of Thinking for Yourself at Get Rich Slowly, that study hasn’t exactly ever happened.

Another research project indicates people do spend more with credit cards

A published study by researchers at Carnegie Mellon, Stanford and MIT, indicates that people  “spend money ’til it hurts”.   The study appears in the journal “Neuron” and is the most recent from the emerging field of neuroeconomics, which looks at the mental processes that drive economic decision-making.

However, before any of you credit card advocates start overdosing on your blood pressure medications, let me quickly assert that this study DID  NOT prove that people spend more with credit cards than with cash; it only gives credence to the theory.

“Credit cards effectively anesthetize the pain of paying,” said George Loewenstein, Carnegie Mellon professor of social and decision sciences (SDS) and co-author of the paper. “You swipe the card and it doesn’t feel like you’re giving anything up to make the purchase, unlike paying cash where you have to hand over bills.”

OK.  How exactly did the study work?

Remember that these people are, uh, brainy.

In the study, 26 adults were each given $20 to spend on a series of products that would be shipped to them. If they made no purchases, they would be able to keep the money.   The participants viewed the products while lying in a functional magnetic resonance imaging (fMRI) scanner while the researchers studied which regions of the brain activated during each participant’s decision-making process.

With the study participants all wired up, the researchers goal was to learn if their brains would register pain when they saw higher prices.  Guess what?  They did.

An electric moment

“We were so excited when we got the results from the first scans, and saw that the insula, a section of the brain associated with pain processing, activated when subjects saw prices that were too high,” said Loewenstein. “It was an electric moment.”

Scott Rick, the SDS graduate student who worked with Lowenstein on the project, was especially excited when they found that insula activation discouraged spending.

“It suggests that prices do not deter spending purely through thoughts of foregone pleasures, as assumed by standard economic theory, but also through immediate pain,” added Rick.

Restated in my words: “The findings indicate that people decide not to buy because they intrinsically know the purchase. while giving some pleasure, will also cause pain.  When the fear of pain overrides the anticipation of pleasure, people decide not to buy. ”

Loewenstein and Rick, along with Cynthia Cryder, also a graduate student in SDS, are continuing their research on the “pain of paying” — the pain one experiences when paying for purchases.

My thoughts

Far be it from me to second guess brainy researchers, but I think they overstated the results of the study.  While giving strong credence that the brain does register pain when prices are too high, Loewenstein took a leap in logic when he said that the study explains why people spend more with credit cards (less pain than cash).  The problem is that he never actually tested the pain using credit cards versus cash; he only proved there is more pain when prices go up.    I wish the researchers, while they had these 26 adults’ brains all wired up up, would have required them to pay cash and then swipe plastic for the same value purpose.  At least we might have been able to have learned if the credit card pain theory was valid.

In the meantime, I suppose we will have to wait for another study to actually prove whether people spend more with credit cards than with cash.

How about you?  Do you personally spend more using credit cards than using cash?  How do you know?

In contemplating whether to write this post, I weighed the negative aspect of “tooting my own horn” with the positive aspect of helping get more high schoolers some solid financial training. One compelling factor in my decision is that Austin Morgan at Foreigner’s Finances had already shared this info in our recent podcast interview. Soooo…the latter won out, and here is the story of how we were able to incorporate great financial training into the local high school curriculum.

“I wish I had know this when I was younger.”

As our church has hosted Dave Ramsey’s Financial Peace University (FPU) over the years,  the most oft repeated comment from the participants has been, “I just wish I had known this stuff when I was younger.” Our leadership team has been empathetic – we all wish we had developed better financial foundations when we were younger. But one night, after hearing this lament once again, a light bulb came on for team member Lisa, “Maybe we can’t turn back time, but surely there is something that we can do to help our current generation of young people learn these principles.”

A lively discussion ensued, resulting in assignments. Mine was to learn if such an agenda existed. Lisa and Tami were charged with learning what was currently being taught at our community high school.

Getting our foot in the door

I learned that Dave Ramsey does indeed have a program designed specifically for high school students. Lisa and Tami learned that economic theory (not personal finance) was being currently taught. So Lisa and I (with the support of our team) forged ahead, making an appointment with the principal to solicit interest in the Dave Ramsey high school version of FPU. Although the principal was open to the idea, he needed to figure out how to integrate it into their curriculum and also get his business teacher on board. Red tape? Yes. Unfortunately, the business teacher, who was close to retirement, was less than enthusiastic about starting something new. The principal respected the teacher’s wishes and FPU for students went on hold.

A break through

We bided our time. The next school year, the business teacher had retired, the principal had become superintendent, and a new principal was appointed. Lisa and Joe tried again, with much better results. We met first with the superintendent – former principal – who encouraged us to meet with the current principal. More appointments, scheduling and meetings were required. We gave Principal Detering a copy of the Dave Ramsey syllabus, along with an introductory DVD about the class, “Foundations in Personal Finance.” We also offered to pay for all class materials. It was Spring, 2008. Principal Detering and class teacher Linda Wood enthusiastically endorsed the Dave Ramsey curriculum and agreed to integrate it into the Fall, 2008 agenda. The best news? Foundations in Personal Finance became a part of the class “Resource Management”, a requirement for all seniors.

The cost

“How much,” some of you are asking, “did this cost?”

Hey. I would be disappointed if you didn’t ask. After all, we are talking finances here. We had two basic choices: both involved purchasing the training DVDs featuring Dave Ramsey, but one option was to purchase individual student books while the other was to purchase a CD containing the book information in printable format. Option one cost less for the first year, but, because the student books would need to be replaced every year, would become more expensive the second year and each succeeding year. Because the second option would require the school to run copies for each student for each lesson, I discussed this option with Principal Detering, who readily agreed. Our total cost, therefore, for multiple years of great financial lessons for all high school seniors, came to $700.

How has it gone?

While I wish I could say that this class has revolutionized personal finance for every graduate, this is not the case. However, I am not surprised. No one at any age will “get” personal finance unless and until they are ready to learn. And while Dave Ramsey appeals to some high school students, he comes across as corny to others. Still, several have given me cause for hope. When I visited the class toward the end of last school year, I asked, “OK.  What is Baby Step One?”  I was pleasantly surprised to see  numerous hands shoot upward. One senior asked me the best way to start her own Roth IRA. Several told me they want to make it through college debt free. And one upcoming entrepreneur, as a way to earn extra money, baked home made cookies to sell to fellow students while they dined on school lunches. Although Principal Detering had to curtail this endeavor, he nevertheless admired her initiative.

Concluding thoughts

I have zero regrets about getting this program into our local high school. Yes, it took some perseverance (and expense) to get it done. Some students roll their eyes and figuratively put their fingers into their ears. But…some are getting it.

These make the effort and expense all worthwhile…many times over.

What are the high school students in your community learning about personal finance?  Have you been involved?  How did it go?

Does one size really fit all?

photo credit: rejon

Before you jump to the wrong conclusion, let me state that the purpose of this post is not to trash Dave Ramsey. Just check my “About” page to read how Dave, his teachings and his books have turned my life around. You will also read that I am a Dave Ramsey certified counselor. I drank the kool-aid and followed Dave’s Baby Steps to dig myself out of debt, build my emergency fund and pay off my house. I will readily attest that Dave’s teachings work.

However, months of exposure to the personal finance blogging community have helped me realize that Dave’s “one size fit’s all” message doesn’t apply in every case to every person. My point is not to fault Dave; it is to encourage people to think beyond the Dave Ramsey formula and clearly understand why they are doing what they are doing.

Some examples:

Debt snowball

This is one I have seen debated ad nauseam in the blog sphere. Nearly everyone agrees that a debt snowball is a good idea; but disagrees on how to structure it. Dave says lowest debt to highest debt, stressing the importance of those early victories that fuel the debt free fire. Dave is famous for his observation that personal finance is 80% behavior and 20% math. Others say highest interest rate to lowest interest rate. Still others have a hybrid plan…I recommend reading Matt Jabs’ post “Pay Off Debt – The Hybrid Debt Snowball Fight” for a great explanation of his hybrid plan and (more importantly) the thinking behind it.

My point is this: debt needs to be attacked with a vengeance, but not everyone is motivated in the same way. Some people (usually the math nerds) are MORE motivated by getting that high interest debt paid off first, even if they don’t get that quick victory that Dave’s method achieves. Others, like Matt Jabs, will be highly motivated by devising a plan that works for his family. My thought: attack your debt in a way that will keep you motivated and on track for however long it takes.

Credit cards

Here we go. Dave, of course, is adamant about the many evils of credit cards. Yes, credit cards get lots of people into lots of trouble, but the debate reminds me of the gun ownership debate: do guns kill people or do people kill people? My wife and I have not owned credit cards for years and have not missed them one iota. But I have met too people who use credit cards responsibly (and who do extremely well financially) to believe that Dave’s “No Credit Card” rule should apply to everyone.

Don’t worry about your FICO score

Dave is absolutely correct in challenging people not to “worship at the FICO altar”. Too many people get way too freaked out about their credit scores, and Dave is on target teaching people not to go into debt in order to build their credit scores. In fairness to Dave, I have never heard him tell people to trash their FICO scores, but he is quite proud to proclaim that his is zero because he hasn’t borrowed money in many years. The inference is that FICO scores are irrelevant, but they aren’t. Insurance companies regularly use credit scores to determine insurance premiums and a good score helps with a home loan if manual underwriting is not available. A recommended read on the topic is FICO Scores Matter: Sorry, Dave Ramsey at Money Help for Christians.

Always get a 15 year fixed rate home mortgage

Fixed rate? Definitely. 15 year? Hmmmm. Are there times when stretching the loan farther makes sense or should all home buyers in all circumstances always get 15 year mortgages? Dave’s criteria are to be out of debt, have a 3-6 month emergency fund in place and set your price range by buying a home on a 15 year note that will keep your payments at 25% or less of your take home pay. Great guidelines, but what if there are no safe neighborhoods in your price range within driving distance of work? Or what if one of the incomes in a two income family is fragile? Or if one spouse is contemplating becoming a stay at home parent? Would there not be some wisdom in giving some cushion by stretching the loan to a 20 or even a 30 year time. To dig a little deeper in how the interest rate itself affects the comparison of loan terms, read Joe Taxpayer’s A Thought on 15 vs 30 Year Mortgages.

Reverse mortgages

I know. Reverse mortgages are more debt and a terrible financial product. I agree. My point is to push the envelope enough to ask, “Are they always wrong?” I recently wrote a four part series on reverse mortgages, arriving at the conclusion that no one should get one without trying every other conceivable option. But I could see that if a senior was emotionally attached to the family home, leaving an inheritance was a non issue and he could use some extra cash flow, a reverse mortgage could be a positive option.

Summary

Dave Ramsey is a financial guru. He has probably helped more people escape financial bondage than any individual alive. His books are full of clear and well articulated advice. I don’t think anyone would go wrong by simply doing what he says. It works. But my challenge in this post is to make people understand why they do what they do. By doing so, they will usually discover that what Dave teaches is what they should do. But, because one size doesn’t always fit all, they may be able to streamline their finances to better meet their individual circumstances.

After all, isn’t that what makes personal finance personal?

Readers: What other exceptions can you think of for Dave Ramsey “one size fits all” advice?

This post was included in the following Carnivals:

Yakezie Challenge Carnival #7 hosted by Money Reasons

Best of Money Carnival hosted by Credit Card Offers IQ

Carnival of Financial Planning hosted by The Skilled Investor

photo credit: db*photography

Congratulations! When you reach Baby Step 7 you have come a long way. All of your debt is gone, including your house mortgage. You have a great emergency fund, your children’s college is well funded and the positive cash flow you used to accomplish the previous steps is still flowing. Only 2% of Americans reach this pinnacle.

A somber quote from Dave: “If you think wealth will answer all of your questions and make you trouble-free, you are delusional. I have had wealth twice in my life, and I don’t find it to be trouble-free; as a matter of fact, most of the troubles have zeros on them. Wealth is not an escape mechanism; it is a tremendous responsibility.”

Responsibility noted, this is also a time to experience one of Dave’s favorite sayings, “If you live like no one else, later you can live like no one else.” But what does “living like no one else” actually mean? Dave says that we can do three things with money: have fun with it, invest it or give it away.

HAVE FUN

Some people, over a lifetime, develop such frugal habits that even when they can easily afford to have fun they don’t. This mindset needs to be changed. Sure, there was once a time when you and your spouse opted not to take that coveted European vacation, not because doing so was wrong but because you couldn’t afford it. Good choice at the time, but today, if you can afford it, do it! Have fun and live like no one else.

INVEST

You have been investing for years, so now is not the time to quit. Whether working with a traditional brokerage or one such as Zecco Trading (which offers commission free trades), Dave recommends staying with simple mutual funds and paid for real estate. You may want to go to more sophisticated investments if you have more than $10 million, but Dave likes simplicity because you don’t want to clutter your life with unnecessary stress that often comes with overly complex investments. And while it is good to surround yourself with a team of people who are smarter than you are, you should always manage your own money. How do you know they are smarter? They can explain complex issues in ways you can understand.

GIVE

According to Dave, if you miss this one, you miss everything. Having fun is great, but all golf or all travel can become mundane and void of true meaning. Investing is a good thing, but if it is the center of your life you will become self consumed with your net worth. Giving is the key not only to what you should be doing with your wealth, but to true happiness itself. “The Great Misunderstanding” in life is that we gain by keeping what we have earned. Not true: true gain comes when we give.

Dave shares these quotes on wealth and generosity:

“There are men who gain only from their wealth the fear of losing it.” Antoine Riveroli

“Surplus wealth is a sacred trust to be managed for the good of others.” Andrew Carnegie

“No one would remember the Good Samaritan if he hadn’t had money.” Margaret Thatcher

When you reach Baby Step 7 you come to a critical stage of life.  Hopefully, you have been generous throughout your life, but it has been difficult to give much simply because you haven’t had much. Now you do. And now is the time to give more than you ever dreamed possible. Now is the time when all of your sacrifices through the thin years will start paying you dividends. And now is the time to share those dividends. Have fun with it. Buy that struggling single mother a car. Provide a scholarship for students who can use a hand up. Give your waitress a $100 or $1000 tip. Your generosity will be your gain…think Ebenezer Scrooge after his night of visitations.

Your life is headed for some great adventures. It is time to live like no one else!

photo credit: rutlo

Dave cautions people who reach this step that they are in grave danger: danger of settling for “good enough” when, if they keep the course, they will experience “best”. People need to remember that the financial plan is like a marathon; slow and steady wins the race. However, the 18 mile mark for many marathoners is when they hit the wall and drop out.

Baby Step 6 is the 18 mile mark of the Total Money Makeover. Arriving at step 6 generally means you have been on the plan for several years. You have paid off all debt except your house. You have saved at least three months of expenses into an emergency fund and have started investing 15% of your income toward retirement. You are saving for your kid’s college and are now poised to pay your home off early. Dave points out that the time frame from beginning on Baby Step One until getting the home paid off is commonly seven to eight years.

Just to be perfectly clear about how the Baby Steps work, we need to explain that Steps 4, 5 and 6 work together. Step 4 is investing 15% of your income for retirement, but all cash flow above that 15% needs a name or else it will disappear. Step 5, saving for college, is your first priority for this “extra” cash flow and all above what is needed for college should be used to pay extra on the house.

Responses to Two Common Objections to Paying Off Mortgage Early

Objection One: “It is wise for me to keep my home mortgage so I can get the tax deduction”. Dave uses this example: if a person is pays $10,000 interest on his mortgage in a year, he can pay taxes on $10,000 less income that year. If he is in the 30% bracket he will save $3,000. It is not smart to intentionally pay $10,000 in order to save $3,000.

Objection Two: “It is wise to borrow all I can against my house because I can make a higher return investing than the interest rate I pay on my mortgage”. According to Dave, there are two problems with this plan.

The first is that taxes or capital gains will eat up much of what you plan on making. For example, if you are paying 4% interest on your mortgage and you can make 8% with an investment, you aren’t really clearing that 4% difference.

The second is the risk. Suppose you intentionally did not pay down $100,000 on your house and you are injured or your job gets downsized or the real estate market nosedives? These are the very problems that brought on many foreclosures in the recent recession and exactly what Dave Ramsey has been warning people about for years. One of his favorite quotes is, “100% of all foreclosures had mortgages on them.”

Types of Loans to Avoid

The problem with a 30 year loan is the huge interest one pays. For example, with a $110,000, 7% mortgage, one would pay $256 more per month for a 15 year loan when compared to a 30 year loan. However, the total payout on the 15 year term is $177,840 compared to $263,520 on the 30 year loan…a savings of $85,680!

Dave also strongly advises against Adjustable Rate Mortgages (ARMs) and Balloon Payments. Why? Too much risk. Rates seldom adjust downward and you are not positive you will be able to refinance or sell when a balloon comes due. Again, these risks have been huge factors in the foreclosures in the past few years.

Dave likes a 15 year fixed rate loan. No surprises and get it paid off as soon as possible.

The Grass Feels Better Under Your Feet

While the financial purpose of getting the house paid off is to free up that cash flow for building wealth and being very generous (see Baby Step 7), there is an emotional aspect too: the grass simply feels better under your feet. You want to go out and roll in the yard because it is totally yours. The freedom of owning your own house outright is extremely liberating. You were already debt free except for the house; now you are totally debt free. You owe no one anything. It is hard to put this in financial terms, but we are talking about financial peace here and having a paid for house is a pinnacle of peace.

My Own House Story

Janice and I bought our house on a 15 year fixed rate loan in 1973, but over the years we kept taking out home improvement loans. We even refinanced one time and rolled our car debt onto our house loan. Janice mentioned several times that we should get serious about paying it off, but I was the “genius” who didn’t want to get rid of the tax deduction. Only after we started our own Baby Step plan and worked our way to Baby Step 6 did we focus on paying off our house. We accomplished Step 6 about four years ago and I have to admit that Janice was right all along. Having a paid for house and being totally debt free is much more liberating than I would have ever dreamed. The grass really does feel better under my feet. Guys…listen to your wives.

photo credit: Will Hale

Just getting to Step 5 indicates that you have been doing some great things with your finances. You are debt free, except for your house and you have a fully funded emergency fund. You are also investing 15% of your income toward retirement. Congratulations! Now, and not until now, is the time to save for your kid’s college.

Keeping the College Education in Perspective

If you, as a parent, have been struggling with guilt because you have not yet saved a penny for college, you are in good company. But Dave points out that our society often considers a college education as a magical “genie in a bottle” that guarantees success. He dispels this notion with several observations. Here are a few:

• The purpose of college is to gain knowledge. The degree is only a piece of paper.
• College degrees do not guarantee wealth.
• College degrees to not even guarantee a job.
• Success in life is a result of attitude, character, perseverance, vision, diligence and extreme levels of hard work. These need to be added to the knowledge gained in college in order to do well in life.
• Dave attributes 15% of his own success to the knowledge he gained in college and 0% to the degree itself.

Hopefully, these thoughts will help you keep college funding in perspective. All of the previous baby steps are essential for financial well being; saving for college, while important, is not essential.

But College is Important

Less you think that Dave is trashing college, he isn’t. He is a college graduate and his children are either college graduates or on their way to completing college. A college education is not up for debate in the Ramsey household. It is important, but, as pointed out above, not a magic recipe for success.

So How Does One Save?

In case this isn’t crystal clear, let me explain how much money you have to use for college savings. Baby Step 4 is 15% of your income toward retirement. The college savings comes from any additional cash flow you have in your budget above that 15%. If you have zero extra, then you can’t do any college savings. The following is for those who have cash flow above that 15%:

Dave stresses the importance of using tax advantaged college savings programs such as the ESA (Educational Savings Account) and the State 529 Plan. Both offer the same tax advantages: all growth is tax free.

The ESA is limited to a $2,000 annual contribution per student and is limited to $190,000 AGI (adjusted gross income) phased out to $220,000 for married filing joint return taxpayers. The 529, on the other hand, has no income limitations and in some states, contribution levels of up to a total of $360,000. There are other differences in these plans and one should study them carefully before deciding which to use.

Dave prefers the ESA because it is highly flexible; the owner can choose virtually any stock or mutual fund to invest in. Some states offer 529 plans with great flexibility but Dave warns against those that offer “life phase” plans because they are so conservative that they earn little return.

Whether using an ESA or a 529, the important thing is to actually do the college savings.

What to do When You Don’t Have Much or Any Time to Save

If your child is near college age and you haven’t been able to save for college, Dave has lots of suggestions for getting your children through college without incurring debt. The key is to decide that debt free college is possible. Once that decision is made, your creative juices will start to flow. Here are some ideas:

• Attend community college for the first two years. For many, this is basically free education. Work and save during these two years to be prepared for the following two years.
• Attend a state university, not a high dollar private school, for the following two years. Your goal is a college education, not a pedigree.
• Apply for scholarships…lots of them. Dave tells of Denise, one of his listeners, who applied for 1,000 scholarships. She got turned down 970 times, but the 30 she received were worth $38,000! Not a bad summer’s work!
• Look for companies that offer co-op work/tuition programs.
• Work! All summer and part time during college.
• Consider military or National Guard. You will qualify to get some or all of your education paid for.
• Delay college. If the money just isn’t there, work for a year, live on nothing and save.

Summary

A college education, while very important, is not a magic formula for success in life. If you have completed the previous baby steps and can afford to save for your children’s college, by all means do so. Take advantage of tax advantaged college savings plans.

If you simply can’t afford to pay for all or even part of your children’s college, encourage them to be creative about making it through without debt. Ultimately their education is their responsibility. The work and sacrifice they make during these college years will prepare them for success in life. Not handing it to them for free may be the best gift you can give.