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?

“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. 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 Home 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.

Congratulations! You have done lots of hard work and have demonstrated great discipline in the process of Dave Ramsey’s Baby Steps. First, you saved $1,000 in a small emergency fund (Step 1), which gave you a buffer against life while you strategically paid off all debt except your house (Step 2) using the debt snowball. With your debt gone, you were able to use that cash flow that had been going toward debt reduction to build up 3-6 months of expenses in your fully funded emergency fund (Step 3). You are debt free with a healthy safety net. But now is not the time to relax. In fact, this is when things start getting fun. It is time for Baby Step 4 : investing 15% of your household income into Roth IRAs and pre-tax retirement plans.

Why 15%?

“Why”, you ask, “does Dave recommend 15%?” Good question! Baby step 5 (college funding) and 6 (pay off house early) give us the answer and help us understand why all of these steps work together.

First, 15% is doable because you have already created the great cash flow in the previous steps. And 15% is an amount that, in most scenarios, will create a nest egg sufficient for retirement with dignity. So the question becomes, “What if I want to contribute more than 15% or less than 15%?” The problem with contributing more than 15% is that you are shortchanging your other financial goals: namely college funding and paying off your house. Dave’s plan is for you to not only build up your retirement fund, but also help with college funding (if applicable) and get that house paid off early.

On the other hand, if you decide to contribute less than 15% for your retirement because you want to help with Junior’s college or pay extra on your house, you are risking your retirement. That paid for college diploma will not put food on your table when you retire. And being 75 years old with a paid for house and no money is not a cheerful prospect.

What Kinds of Investments Does Dave Recommend?

This discussion has two components: the tax treatment and the actual type of funds you invest in. First, the tax treatment. Dave loves the Roth IRA because you pay your taxes upfront and then allow the fund to grow tax free. Yes, ALL of the growth is tax free, meaning when you draw the money out at retirement, you pay ZERO taxes. So why does Dave put the 401(k) ahead of the Roth? Simple: the employer match is free money. The plan is to get all the free money you can get, then invest in Roth IRAs. If you max out the allowable Roth investment ($5,000 in 2009 for those under age 50), you then go back to the 401(k) until you hit 15%.

Example: Jim earns $100,000 annual income. His employer will fully match up to 5% of his 401(k) investment, so Jim, in order to get that full match, will invest $5,000 into his 401(k). He then moves to the Roth IRA and maxes it out at $5,000. His total investment is now $10,000 (10% of his income) so he goes back to the 401(k) for another $5,000 with will bring him up to a total of 15%. Note that you don’t use the 401(k) match as part of the 15% … this percent should all come from your income.

Simply put, it looks like this:

• First investment: 401(k) up to full match
• Second investment: Roth IRA until it is maxed out.
• Third investment: Back to the 401(k) until you reach 15% of your income.

What Types of Funds Does Dave Recommend?

Because Dave loves both diversification and mutual funds, he recommends a diversification of mutual funds. He does not make specific fund recommendations, but does recommend the following mix of mutual funds:

• 25% Growth
• 25% Growth and Income
• 25% Aggressive Growth
• 25% International

Dave recommends only mutual funds that have at least a 5 year track record, and preferably 15 or more years of positive performance.

So How Does This Play Out?

With the recent craziness in the world of investments, some say we shouldn’t be putting money in the stock market. Admittedly, there is cause for concern. But what choices do we have? Dave points out that unless we believe that all of the major companies in our nation are going to fail, we are wise to continue to invest.

Our hypothetical couple, Bill and Karn, are both 35 years old and make a combined $60,000 income. Their 15% investment would be $9,000 annually. A 10% annual return would give them a nest egg of about $1.7 million at age 65. If they drew 4% annually from the nest egg, their retirement income would be $68,000 annually. This number is not adjusted for inflation, but we also didn’t adjust their increased contributions as their incomes increased over the years. With no debt and a paid for house, they should do all right at retirement, especially if Social Security is still around.

photo credit: eikosi

Peter and Teresa (not real names) were doing well. Peter had a good paying job with great security. Teresa brought in extra money through being self employed. Life was good until, with no warning, Peter had a heart attack necessitating him to miss six months of work. His sick leave covered his pay for the first month and his health insurance covered all medical expenses, but for five months he had no income and no way to earn income. On top of this, Teresa had to quit her work so she could stay home and take care of Peter. They borrowed from friends. They took out a personal note from the bank. And they used their credit cards…and used them. Their car was repossessed and they barely avoided foreclosure.

Fortunately, Paul recovered sufficiently to go back to work, but he and Teresa now have so much debt that their take home pay is not enough to cover their minimum monthly payments. Teresa had lost her clients from her previous work and is working a minimum wage job. Their stress level is so high that Peter is concerned about another heart attack.

Of course we can’t roll back time for Peter and Teresa, but if we could, I am sure that they would build up their emergency fund. Had they done so before Peter’s heart attack happened, they would been able to pay for the ordeal without creating new debt.

So What Do We Mean By a Fully Funded Emergency Fund?

First, a quick review of steps One and Two. Baby Step One is saving $1,000 for small emergencies. The purpose of the $1,000 is to provide a buffer account for unexpected expenses while paying off debt. Baby Step Two is paying off all debt except the house by using a debt snowball.

Once Baby Step Two is complete, Dave Ramsey recommends saving three to six months of expenses in the emergency fund. The purpose is, for the rest of your life, to keep a fund which will tide your through whatever emergencies you might encounter. It is akin to Grandma’s “rainy day fund”. This step is an essential part of financial planning; virtually all financial planners recommend an emergency fund. The question is not IF an emergency will come into your life, but WHEN. Money magazine says that 78% of us will have a major emergency within any given 10 year period.

Keep Up the Momentum

After being so focused during Steps One and Two, it would be easy to relax a bit. I do think a celebration is in order: becoming debt free is a big thing! Save up and pay cash for a get-away, but be aware of the temptation to raise your standard of living. After all, you now have a great positive cash flow because all of the money you had been spending on debt is now at your fingertips and will disappear if you don’t immediately give it a name. And that name is crucial: emergency fund. So Step Three is a natural progression from Step Two. You have already done the hard work of squeezing your life style to create the debt snowball payments, so now is the time to use that same cash flow to start paying yourself. You have momentum on your side. Keep it up.

How Much?

Dave recommends three to six months of expenses. With no debt payments except your house, many families can live on $3,000 a month, so the emergency fund should be a minimum of $9000. Of course single income families, employment in industries vulnerable to economic downturns or families where both spouses work for the same employer are most susceptible to emergencies. With today’s unemployment and stuttering economy, six months is more prudent and nine months would not be too much for most. If you were previously paying $1500 a month toward debt, then you should be able to complete Step Three in six to twelve months.

Where to Keep the Money

Dave recommends keeping this emergency money easily accessible. This is not considered an investment but a savings, so don’t expect the fund to be a money maker. A high yield savings account or a money market account are good choices.

Side Benefit: Better Marriage

Because the emergency fund creates security, it is a very high value for most wives. Husbands…did you hear that? Even if you aren’t excited about a block of money sitting around “gathering dust”, you need to remember how important the emergency fund is to your wife. Don’t start thinking you need to be doing something fancy with this money. Instead, consider it a great investment: an investment in a content and secure marriage. After all, your goal is financial peace.

Next up in this series is Baby Step Four: Investing 15% of your income toward retirement.

In light of the roller-coaster economy over the past year, many people have asked if Dave has changed his views on anything or rewritten any of his fundamental teaching principles. The short answer is, “NO WAY!”

Dave’s teaching principles aren’t based on month-to-month shifts in the economy. What he teaches is nothing new; it’s just God’s and Grandma’s ways of handling money. These are timeless truths that don’t change, regardless of how the market performs.

So, let’s take a look at a few specific areas that we’ve been getting a lot of questions about.

Investing

Dave has said time and again that most people who get into trouble with their investments are those who try to time the market. That is, they put their money in, take it out, move it around and mess with it! That’s a HUGE mistake! You should keep investing in both good and bad times.

A full 100% of 15-year periods in the stock market’s history have made money. That’s 100%! Like Dave says, you don’t get hurt on a roller coaster unless you jump off!

In July of 2009, the Dow Jones increased 8.6%. That’s the best July performance in a decade! And the S&P 500, a listing of the 500 largest companies in America, was up 7.4% in July 2009. That’s the best July performance for the S&P since 1997. Not only that, but it’s up 34% since March 2009! If you got out of the market, you missed the growth!

Real Estate

Yes, foreclosures have been up lately. A lot of families who bought their homes with nothing down or stupid interest-only loans got stuck in a bad market and are losing their shirts. For a while this spring, it seemed like all the news media talked about was how bad housing was in America. But here’s the truth: 60% of the foreclosures occurred in only five states—Nevada, Florida, Arizona, California and Colorado.

Dave firmly believes that real estate will be the area that leads us out of the recession. It’s happened before, and it will likely happen again. One of the reasons is pent-up demand. Even though it’s a hard time to sell a house, people are still moving. They get transferred in their jobs or take a new job in a different city or need to move home to take care of their families. Life doesn’t stop happening when the housing market takes a hit.

The housing market is flooded with inventory right now, which has kept prices low. However, the cost of new houses really hasn’t changed much, because the cost of construction materials hasn’t changed. So, as the available inventory starts to burn off, prices will start to go back up because they’ll have to compete with the higher new home prices.

Manual Underwriting

If you do the things Dave teaches, like getting out of debt and cutting up your credit cards for good, your credit score will eventually drop to zero and become what’s called “indeterminable.”

The thing is, though, most mortgage lenders use only your credit score to determine whether or not to give you the home loan. They don’t really look at you at all; they just care about your three-digit FICO score. So, if you don’t have a credit score because you’ve gotten your financial act together, these lazy lenders can’t—or won’t—help you.

In that case, you’ll need to see a lender who does manual underwriting. These mortgage lenders actually take the time to see who you are, what you do, what your current financial position is and more. Our friends at Churchill Mortgage assure us that manual underwriting is still alive and well, and they’re approving these mortgages at A+ rates every week.

So What?

If the economic downturn made you pay attention to your money for the first time in your life, then that’s a blessing—even if it came with some pain. Pain is like that, you know. It can be helpful and instructive. It shows us where we’ve gone off track and points us back in the right direction. That’s always a good thing!

So don’t be afraid of the pain. Face it. Deal with it. See what it’s showing you. Correct the problems it is highlighting in your life. Clean up the messes it is uncovering. The economy won’t be bad forever. Make this the year you turn your life around.

photo credit: OakleyOriginals

In order to better understand Dave Ramsey’s passionate hatred of debt, allow me to quote him,

“ Years ago, my wife, Sharon, and I went broke. We lost everything due to my stupidity in handling money, or not handling it, as the case may be. Hitting bottom and hitting it hard was the worst thing that ever happened to me and the best thing that ever happened to me.

“We started with nothing, but by the time I was twenty-six years old, we held real estate worth over $4 million. I was good at real estate, but I was better at borrowing money. Even though I had become a millionaire, I had built a house of cards. The short version of the story is that we went through financial hell and lost everything over a three-year period of time. We were sued, foreclosed on, and, finally, with a brand-new baby and a toddler, we were bankrupt. Scared doesn’t begin to cover it. Crushed comes close, but we held on to each other and decided we needed a change.” (from the Total Money Makeover)

It was this experience that drove Dave to learn how to do it right the next time. He read extensively, interviewed older wealthy people who had made money and kept it, and studied the bible. His conclusion is that debt brings on risk and should be avoided.

Over the ensuing twenty years, Dave has helped millions of people achieve financial peace by emphasizing the debt free theme that he is famous for.

Now: Baby Step Two…The Debt Snowball

More specifically, Baby Step Two is paying off all debt except the house, which will be covered in Baby Step Six. How is this accomplished? By using the Debt Snowball. What does Dave mean by Debt Snowball? List all debts from smallest to largest, then make minimum payments on all but the smallest until it is gone. Then roll that payment to the next smallest until it is gone, still making minimum payments on all others. The payments on the smallest debt continue to increase as each one is paid off, thus the term “snowball”.

Math versus Behavior

I want to stop at this point and address the accusations that “Dave Ramsey doesn’t know math.” People often point out that, mathematically speaking, the debt will disappear faster by starting with the highest interest rate instead of the smallest debt. Dave, who has a degree in economics, does know math and will readily agree that working from highest interest rate to lowest is indeed mathematically advantageous. So why does he teach paying smallest to largest? Because Dave also understands human nature. He preaches that personal finance is 80% behavior and 20% head knowledge, so he developed a simple plan that gives quick victories at the onset to help gain enthusiasm, confidence and momentum. These Baby Steps, by changing behavior, often motivate people to make more sacrifices (selling an expensive car, temporarily working a second job, foregoing a vacation, etc.) as they see their list of debts disappear. Paying month after month on the same debt because it has high interest can become dreary, causing many to give up because they don’t experience those victories.

This being said, the point is not to nit pick about which type of Debt Snowball one uses, but to get through Baby Step Two as quickly as possible. It is just that Dave has been doing this for many years and has helped millions get out of debt. His “behavioral finance” works, so I recommend giving it a try. If you discover that you are more radically motivated to focus on the high interest debt first, then by all means do so!

Thoughts on Debt Snowball

• This step is simple but difficult. Remember: most people actually gain momentum as they plot their progress.
• Married couples: make sure you are in total agreement before starting this process. Together you can accomplish amazing results, but it is nearly impossible for only one spouse to make this work.
• Helpful hint: put your debt snowball list on the refrigerator and draw a huge red line through each debt as it disappears.
• Work on your budget every month. It is the difference between income and outgo that gives you the cash flow to achieve a really big snowball.
• Set a challenging time goal. If you know you can be debt free in 24 months, set a goal of 18 months. You will be surprised at how creative you can become once you set a goal.
• Consider the sacrifices you can make to get the snowball rolling. We sold a $20,000 van and paid cash for a $5,000 station wagon.
• You will know that you are doing things right when your broke friends and relatives think you are weird. Getting out of debt is indeed weird in today’s world, but this is one kind of weird that you will enjoy.

Next in series: Baby Step Three…Fully Funded Emergency Fund.