Wiser Financial Advisor – Baby Steps to Financial Freedom, Part One
Hi, Everyone. Welcome to the Wiser Financial Advisor with Josh Nelson, where we get real, we get honest, and we get clear about the financial world and your money.
This is Josh Nelson, Certified Financial Planner and founder and CEO of Keystone Financial Services. We love feedback and we’d love it if you would pass it on to me directly at firstname.lastname@example.org . Also, please stay plugged in with us and get updates on episodes and help us promote the podcast. You can subscribe to us at Apple podcasts, Google, Spotify, or your favorite podcast service. Let the financial fun begin!
In the movie, What About Bob? we meet Bob Wiley, played by Bill Murray, and we learn that Bob is a nice guy but he suffers because he has multiple phobias so intense that he has a hard time even leaving his own apartment. He goes to a therapist and Dr. Marvin gives Bob a book he wrote called Baby Steps. Dr. Marvin explains how these baby steps work and Bob tries them out. He takes baby steps around the office and baby steps out the door. And he comes back in and says, “It works. All I have to do is take one little step at a time and I can do anything.”
Financial expert Dave Ramsey created his own version of Baby Steps, and he uses the same principles found in Dr. Marvin’s book, only the focus is on finance. The key here is to focus on one thing at a time and take consistent action toward where you want to go.
Here at Keystone Financial Services, we use Dave Ramsey’s baby steps. Today we are going to cover steps one through three. But before we jump into the baby steps, I think it’s important to get clear on what’s the point of all this? Why are we talking about this?
I’ve been a financial planner for over 22 years. Most people have a couple of things they want financially. Really, it boils down to a couple of things.
Number one, people want to have a sense of financial peace of mind, meaning that they want to get out of financial stress. They don’t want to have to be worried about their money.
Number two, people’s ultimate financial goal is financial freedom. You can use different words for this. Some people say retirement, some say financial security. But at the end of the day, it really means ultimately that what people want is an income that pays for the life that they want for the rest of their life.
That’s the destination that we are after. We want not only some peace of mind today that you’re going to be OK, but also a long term plan that has a high likelihood of working out and you feel good about it.
Let’s jump right into the financial Baby Steps.
Baby Step One is to save up a thousand dollars for a starter emergency fund. We’ll call this the baby emergency fund.
Those of you who are further along the path might say, “Well, that’s a little too basic.” But the bottom line is that most people don’t have a thousand dollars on hand. In fact, the Federal Reserve has done a study on this and said that the majority of Americans can’t actually come up with a thousand dollars if they have some kind of small emergency. So, if you’re starting from square one and trying to figure out “Where am I?” Baby Step One is to get a thousand dollars for your starter emergency fund.
Where should that money go? It should go into a savings account or a checking account or something that’s really safe, really liquid. And I think that it should be separate from your normal spending account. So personally, I don’t think the checking account is a good place for this money. Even if you can see it at your bank or credit union when you log in, you should see it in a separate bucket of money. That way, in your mind you know, “That’s my emergency fund.”
Baby Step Two is to pay off all your debt except for the house by using the debt snowball approach. (Link to Debt Snowball episode)
We’ve actually done a whole episode on the debt snowball in the past. And we’ll revisit it time and again, because this is an area that trips people up like crazy. The debt that they’ve accumulated creates a lot of financial stress in people’s lives. We’re not going to get into why it gets there or people’s bad decisions, things like that. At the end of the day, we can’t go back and change the past. All we can do is focus on the future. So Baby Step Two—paying off all your debt—is an important way to achieve financial peace of mind and have a sense of financial security.
What is the debt snowball? Very simply, the idea here is that you take every dime you can scrape up in the month and apply that toward the smallest debt first, while making the minimum payment on all other debts. Take all your extra dollars, put them onto that smallest debt until it’s paid off. That frees up the money you needed to put toward some kind of payment on that smallest debt. You’ve freed up some cash flow and so now this next month, you’ll have a little bit of extra money. You apply it to the next largest debt and then the next largest debt until they’re all paid off. Don’t worry about the interest rate. Or if it’s a personal loan, don’t worry if so and so said that maybe you have to pay it back, maybe you don’t. Everything you owe goes on that list of your debts.
It’s very character building, paying off debt. There is a sense of relief. I’ve done it myself over the years, paid stuff off. It feels really good. And the reality is, if we get payments eliminated now, we’ve got more and more free cash flow per month, not only to pay off debt, but eventually to move on to the other baby steps and save for things that are really important–like investments and retirement, things like that. So the debt snowball is key. Again, go back and listen to the other episode on the debt snowball and really take this to heart, because it’s been proven in many studies to eliminate debt faster than any other method.
One thing I will caution you about again: Do not pay attention to the interest rate. That’s a trap. Also, do not consolidate debt. That is also a trap. In almost all studies I’ve seen, it results in people taking longer to eliminate their debt. So it doesn’t matter what the interest rate is, pay off the smallest one first to get very aggressive and very focused on paying off debt.
That brings us to Baby Step Three.
Baby Step Three is funding a bigger emergency fund. Remember, we had a baby emergency fund before with a thousand bucks. Now we’re actually saving a larger amount of money for a fully funded emergency fund.
Different people will use different figures for how much should be saved. I think Dave Ramsey says three to six months of expenses. Personally, I think three to twelve months depending on the situation. I say that because situations differ. Some are very stable, some are unstable. Some people have a kind of a guaranteed income coming in. Maybe they’ve got a lot more security and they don’t have to have as much in cash to fund emergencies or a loss of income. However, if you’re a business owner or if you’ve got a job where you’re paid on commission or something like that, I would recommend saving closer to that full year of expenses because conditions are not guaranteed. Really, any job income is not guaranteed. Bottom line, people can get fired for lots of different reasons. People can get let go even in situations where they didn’t do anything wrong. I’ve seen situations happen where somebody has to leave a job because of medical reasons, completely unplanned. All of a sudden, they’re trying to figure out how to pay the bills. So I think it is very important to look at your situation and how stable your income is, how much certainty there is. Take a look at three to twelve months’ worth of living expenses. And then depending on your situation, you may move up from there. You may go to higher amounts, especially if you’re self-employed or if your income is variable.
Again, where do we put this money? We put it in cash. We just leave it in a savings account separate from normal stuff. That is your emergency money. You do not touch that money. It’s really important with emergency funds, both in Step One and Step Three, to keep that money aside. Mentally, you’ve got to put it in a different place. This is not your fund that you use to pay for vacation. This is not your fund that you dip into because you want to buy something. Again, we’re building financial character. We’re building up some emotional financial character to make sure that we actually do treat that emergency fund as a real emergency fund. It’s there for really unexpected stuff that you have no other way to pay for. Your furnace goes out in the middle of the wintertime or somebody gets sick and you’ve got a medical bill. Those sorts of things are what the emergency fund is for.
Fully funding that bigger emergency fund of three to twelve months’ worth of living expenses is very important. That’s going to take a bit longer. Now, you may be wondering, “Why are we paying off all of our debt? Why doesn’t that come later? Why not save up the emergency fund first?”
It’s important to have some money in the bank, but if you’ve got a bunch of debt, it’s more important to get it paid off. Bottom line, if something crazy happens, you know how to borrow it. That’s how you accumulated the debt to begin with. So it’s more important just to knock all that stuff out. Get it gone. The more debt you eliminate, the better position you are in financially. And these days, the interest is not real high on savings accounts and checking accounts anyway, so it’s not like your earnings are going to be very high by leaving it in the bank. Almost certainly you’re going to be paying more interest on whatever debt you’ve got than what you are going to be earning in savings or checking.
Another question that comes up is, “Why did you put the house in a different category of debt?” And we’ll get to that in Part Two of the Baby Steps next week. This week, review the first three:
Baby Step One, save a thousand dollars for your starter emergency fund, the baby emergency fund, just to get something set aside. When you’ve got small emergencies, the money is there. Dip into it only when you have to.
Baby Step Two, pay off all your debt, every debt except your mortgage. One quick question that comes up here: “What about my home equity line of credit? What if I have a second mortgage?” I would say “Yes, those are included on the debt snowball list.” You need to get those paid off, get down to just a normal mortgage payment.
Baby Step Three, get three to twelve months’ worth of living expenses in an emergency fund. Again, remember, this is not investments. This does not go into bond funds. It doesn’t go into stock funds or anything like that. This is money in the bank or credit union where you can access it right away and there’s absolutely no risk associated with it. Three to twelve months. Again, very much dependent on your situation and how certain your income situation is. Get at least three months’ living expenses.
Later on in the movie What About Bob? Bob says to Dr. Marvin, “I’m doing the work. I’m baby stepping. I’m not a slacker.” So your homework is to find out what Baby Step you are on and do the work and don’t skip past any steps, no matter how tempting that may be. Do not try to short circuit the debt snowball by doing debt consolidation or by falling into the trap of saying, “Well, I’m going to pay off the highest interest stuff first, even though that debt is much, much larger.” What we’re concerned about right now is making quick progress and eliminating payments. That’s much more important right now than what interest you’re paying on various debts.
If you’re already past Baby Step Three, hey, that’s fantastic, because now you get to listen to the next episode. That’s something to look forward to as we talk about steps four through seven. I hope all is well and I’m looking forward to talking through the rest of this with you. Remember, the ultimate goal is financial freedom, meaning that we’ve got an income that we can’t outlive and that we’ve got enough money to be able to fund what we need to do today.
Have a wonderful week and God bless.
The opinions voiced in this episode of the Wiser Financial Advisor with host Josh Nelson are for general information only and not intended to provide specific advice or recommendations for any individual. Investment advisory services offered through Keystone Financial Services, an SEC Registered Investment Advisor.