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I just finished reading Dave Ramsey’s The Total Money Makeover personal finance book and I must say that I am inspired! It is a step by step guide on how to become debt free and build wealth. After reading the book, I don’t look at money the same way. I wish someone had given me this advice when I was 18! Unfortunately, most parents do not pass on proper understanding of money and how to manage it.
For those who may not know, Ramsey is a devout Christian and a financial guru. He has written quite a few bestsellers on personal finance. I liked his approach to trying to minimize debt to the best of your ability. Ideally, you should not have debt at all and if you do, then you must try to get rid of it as fast as possible. In Islam, we are also taught to avoid debt to the best of our ability. It is reported that the Prophet Muhammad (pbuh) used to seek refuge with Allah from debt and sin. Once, one of his companions asked why that was the case and he replied, “Whoever gets into debt speaks and lies, and makes a promise and breaks it” [Nas’ai]. In another narration, it is reported that he said, “The soul of the deceased believer remains pending on account of the debt till it (the debt) is repayed” [Tirmidhi].
Ramsey has a whole detailed chapter discussing debt and how awful it is. He is not in favor of it at all and argues, quite convincingly, that you should never borrow money unless it is absolutely necessary. If you can’t afford it, then don’t buy it, which is a pretty solid philosophy. The only exception he makes is for a house mortgage and even that for 15 years fixed and never 30. So if you can’t pay for a house in 15 years, then don’t buy it. This means if you end up getting a smaller house and not your ideal because you can’t pay it off in 15 years, then so be it. The objective is to get out of the slavery of debt as soon as possible. Moreover, the faster you pay off the mortgage, the less you will be paying over time in profit to the mortgage company. This applies to Islamic finance options as well.
He is also not in favor of using credit cards. In fact, he suggests to just cut them up and throw them out, because people can’t control themselves when they know they have a credit line plus there has developed a cultural acceptance of living off credit card debt in America. For us Muslims, this shouldn’t be that big of a deal since paying or charging interest incurred due to debt is strictly forbidden in Islam. It is seen as a form of oppression where the rich take advantage of the poor. Lending is seen as a form of charity in Islam where the one who has a lot is helping the one who does not. In other words, Muslims should not be living off of credit debt in the first place. You should only buy things if you have the money to afford them, otherwise, it is regarded as wasteful.
He provides a seven step plan to overcome financial instability and become a “financial superbody”. He terms them “baby steps” because you do them in order. You don’t move to the next step before completing the one before it. Throughout the book, he stresses that this is the only formula that he knows works because he’s tried and failed multiple times with other methods. This is the formula that he himself has used for his own life. It’s very practical advice, as you will see below insha’Allah, and makes a lot of sense.
I have summarized his steps below but I would highly suggest purchasing the book and reading it through for further details, inspiration, great success stories, and quite a bit of humor. Before I get to the steps, it is important understand two points. First, the book assumes that you are willing to change your habits and way of life. Winning at money is 80% behavior and 20% head knowledge, Ramsey argues. So if you are not willing to make sacrifices and change bad spending/saving habits to cure your financial sickness, then no advice will do you any good. Secondly, Ramsey, like so many other experts on personal finance, emphasizes four main actions that must happen for a person to have control over his/her finances:
- Live below your means
- Stop living off of credit cards, thereby, deepening your debt. If you go to a store and see something you cannot pay in cash within a month, then don’t buy it.
The above actions may seem like common sense but you’d be surprised how many people suffer from it and can’t control themselves.
Here is Ramsey’s seven step process for financial security and building wealth. Remember to follow them in the order below:
Step 1 – Save $1000 cash as a starter emergency fund
Your first step is to save $1000 dollars as fast as possible. This is your emergency money for things like car accident, hospital, burying a loved one, your job downsized, or other unexpected expenses. Shopping for holidays is not emergency. So save up to a $1000 and only spend it on real emergencies. Try to do this as quick as possible, so if it means picking up an extra shift or doing something on the side, then do it.
Step 2 – Start the debt snowball
Once you have your starter emergency fund, then it’s time to go after your debts (except for the home mortgage). So if you have student loans, credit card debt, car payments, etc., then it is time to start paying those off one by one. Ramsey strongly is in favor of the debt snowball method, a debt reduction strategy, whereby one who owes on more than one account pays off the accounts starting with the smallest balances first, while paying the minimum payment on larger debts. Once the smallest debt is paid off, one proceeds to the next slightly larger small debt above that, so on and so forth, gradually proceeding to the larger ones later.
Under this method, once the smaller debts are paid off, the extra cash saved is added to pay off the larger debt in the sequence, hence the term snowball. This method also builds motivation to keep you steadfast and moving forward since the small victories give you a boost in confidence. There have been studies done to show that it is quite effective.
What happens if you have an emergency and your starter emergency fund goes below a $1000? Very simple. You stop the snowball and go back to making the minimum payments on all debts until you’ve refilled your starter emergency fund up to a $1000. Then you go back to attacking the next debt in the sequence from smallest to largest except for the house mortgage if you have one.
Step 3 – Finish the emergency fund
Once you have all of your debts paid off (other than the house if you have one) and you have $1000 in the starter emergency fund, then it is time to finish the emergency fund. A fully funded emergency fund covers three to six months of expenses. In case you lose your income, how much would you need to live off of three to six months worth of expenses? Once you have that number, then your goal at this step is to save to that amount. Again, this is an emergency fund so the same philosophy applies to it as discussed above for the starter emergency fund. Do not use it or touch it unless it is an unexpected expense (car accident, hospital, job loss, funeral, etc.).
Whether you need to fund for three months or six and exactly how much varies from person to person. Ramsey suggests that in his experience it can be anywhere between $5,000 to $25,000 depending on the lifestyle of the person/family. A good way to get an idea is to add up all of your recurring expenses for the past month (utilities, grocery, mortgage, gas, etc.). This should give you a general idea of how much to save. I personally would also suggest to save up to six months worth of expenses just to have that added cushion.
Step 4 – Invest 15% of your income in retirement
They key to a decent retirement income is to start investing early as possible! If I had known what I know now about the power of investment at an early age, I would have started as soon as I was old enough to work! I plan to encourage my kids to open one as as soon as they are old enough to work. This is very important because we don’t know how we will end up in old age. In many eastern cultures, it is usually the children that take care of the parents in old age, hence, they are their retirement plan. In the West, this is rarely the case. Life here is very different. I’ve seen old Muslim fathers in America coming to the mosque begging for zakkat money because they don’t have enough and their children refuse to support them. I have also seen Muslim fathers who invested in their retirement accounts early on and are now retired and stress free enjoying their lives. Point is you don’t know how your life will turn out to be in 30-40 years or what circumstances you will be in, therefore, it is best to invest in your retirement nest egg as much as possible and be prepared.
The idea here is to invest 15% of before tax gross income annually toward retirement. So if your income is $40,000/year before taxes, then every year you should invest $6000 into retirement. That’s about $500/month. If you don’t know what a retirement account is or how it works, then please watch these three short video series. If you decide to open an IRA account, then there is a limit on how much you can put in it every year (as explained in the videos). If you are married, then both of you should open one in your own names because if there is only one income in the house, you can split the money between both to be able to invest more than the restriction.
For example, for the Roth IRA, the limit is $5500/year that you can invest as of 2018 but let’s say your 15% is $6000. Well if you’re married and your wife is a homemaker, then you can each open a Roth IRA account for a total of $11,000 max restriction. So you can put $5500 in one and $500 in the other. The more you put in, the larger it will grow over the course of the decades. If you and your wife either together or solely make enough money to be able to fully fund both retirement accounts to their maximum, then you should definitely do so! Remember, the more you put in, the more you will have at retirement insha’Allah!
If you are wondering which companies to invest in from an Islamic point of view, then please review my post on stocks. In short, once you open a retirement account, then have either all or one of the following mutual funds added to invest in: Amana Growth, Amana Income, Azzad Ethical, Wahed ETF. I personally only invest in Amana Growth and Wahed ETF in my retirement account. Go to broker sites like E-Trade, Fidelity, Vanguard, etc. and sign up! Be sure to compare the various fees and expenses related to the account and choose the most cost-efficient. As for how to calculate your zakat on retirement accounts, then please watch this video.
Step 5 – Save for your children’s college
Ramsey’s general advice regarding college is that to understand, first and foremost, that just because your kids go to college, it does not mean they will be successful because “degrees do not ensure wealth”. This is certainly true. I’ve heard of so many stories of individuals with Masters and PhDs but no jobs. What matters more is hard work, discipline, being responsible with money, experience, personality, and doing your utmost best to get ahead. We need to build resilience and patience in our kids. We need to teach them responsibility and to not engage in financially destructive behavior just because everyone else is doing it.
After having realized the above, the first thing to do is some research on how much a college degree costs nowadays in your area. Ramsey considers the college degree as a luxury, therefore, does not support going into debt for it. And he certainly does not support going out of state for it when you can’t afford it. Sending your child to college within state is far cheaper and as a rule this should be your only choice unless your child has a full scholarship or you have the cash to send them out of state. Taking up student loans when you have the option not to is a terrible idea. I didn’t go straight to a four-year university. I went to my local community college for three years and then transferred to an in state university and completed my degree. I never took loans. My mom paid for everything in cash on a 7-11 salary! How? We applied for FAFSA, a student financial aid program from the U.S. government, which covered the majority of my tuition and she paid the rest in cash!
There has been a lot of discussion over student loans and how it negatively impacts graduates making them fall behind in life. There are even movements now trying to push a free college education for citizens like in some of the European countries. The point is you seriously want to consider the pros and cons before deciding to take student loans. Try to avoid it at all costs!
Fortunately, there is something you can do to help your kid with college. Ramsey recommends opening an Educational Savings Account (ESA), which is funded in a growth-stock mutual fund. It grows tax-free when used for higher education. However, you are only allowed to invest up to $2000/year in it as of 2018, which is about $166.66/month. If you invest $166.66 or even $100 a month in an ESA account from your child’s birth until he/she is 18, you can pretty much afford to send them to any college! You can open an ESA account at most brokerage firms like E-Trade.
There is another option as well. You should have your child apply for scholarships. There are thousands of scholarships available every year. They are not just for those with academic or athletic excellence. Some will give it to you if you are a minority while others just want you to write an essay. There are hundreds of different kinds. I know people who applied and went out of state on scholarships by applying to every scholarship that they could get their hands on. Ramsey in his book tells the story of a young lady who applied to a 1000 scholarships and got rejected by 970 but she got 30. Those 30 scholarships paid for her whole tuition for four years!
Not all parents will be up for or can afford to set up an ESA account. That’s fine. Then focus on other means discussed above or do work-study, where your child works while studying to help pay for school. There are employers who offer such programs through partnerships with various universities. So to sum up, here is how you can help your kid(s) go to college without student loans:
- Apply for FAFSA government aid
- Apply for scholarships
- Apply for work-study jobs
- Open an ESA account in their name early as possible and fund it every month
Remember, this step should not jeopardize the previous steps. You should only do this if the steps before it are complete.
Step 6 – Pay off your home mortgage
This step comes after regularly contributing to retirement because retirement takes preference. Ramsey in the book talks about retired folks that he has advised who have a paid off house but don’t have enough to put food on the table, because they never bothered to invest in retirement! They spent their time trying to pay off the mortgage.
Provided you have completed the above steps and are regularly investing 15% into your retirement and your kid’s college fund (if you decide to go that route), you can now focus on paying off the house with that extra cash you have left over every month. Ramsey goes into some myths about how having a mortgage is better than having no mortgage due to tax deductions and other myths related benefits of being in debt. I am not going to delve into them here, but long story short, being in debt is not good for you and it hurts your wealth potential.
Ramsey strongly suggests buying a home on cash, even if it’s a small one, and to avoid borrowing money. This is because you can use that extra cash that would be going into mortgage to invest to help build your wealth. However, since buying a house on cash is not realistic for most people, even a small house, he recommends doing a 15 year fixed mortgage. If you are already in a fixed 30 year mortgage, then make extra payments and pretend it is a 15 year fixed mortgage. You can use this calculator to figure out how much to give each month to pay it off earlier and the amount of money you will save just by making extra payments on your mortgage every month. According to FDIC, 97.3% of people do not systematically pay extra on their mortgage. Therefore, they remain enslaved to the financial institution for their full terms.
Trying to pay it off in 15 years is the maximum, therefore, if you are able to do even more payments each month after all of your expenses, then do so because you will pay off the mortgage faster. You’ll be surprised how many years are taken off just by adding a few hundred dollars more to your mortgage each month. Ramsey says the average person who takes on these steps pays it off in 7 years.
Step 7 – Build wealth
By this step you should be completely debt free and outside of your recurring expenses, the only payments you have are funding your retirement account and your child’s educational account (if you decide to go that route). It’s all about you now and whatever you are saving up either for retirement, kids’ education, or your bank, it’s all for you and your family and not some other institution. Now you can, as Ramsey puts it, have FUN, INVEST, and GIVE in charity.
Your money is growing tax free in a Roth IRA retirement account and you have extra cash on hand. Even when the market goes down, you’re not worried because you’re in it for the long haul. The market corrects itself and bounces back so that’s fine. You’re patient. Investment is the best way to build wealth. When your money makes more money than you do, then that’s true wealth. This is why it is important to educate kids on how to invest as soon as they are able if we want to secure the financial stability of our children and their children and so on.
As for what to do with that extra cash to build even more wealth is to invest it either in mutual funds or real estate. Mutual funds may be an easier option for most people. You can open a new personal account at a brokerage firm and invest like crazy in mutual funds that have a 5-10 year history of good returns. Since it’s not a retirement account, there is no limit of how much you can put in there. Just remember to stay in it for the long haul and don’t look for short-term returns. Amana and Azzad mutual funds are ethical options for Muslims and they actually have really good performance records!
Investing in individual stocks is not recommended because you need diversity to compensate for the loss of one stock through the benefit of another. If you insist on individual stocks, then pick one with a good track record and stay in the game for the long haul (5-10+ years).
Debt is one of the worst things you can tangle yourself into. It will keep you weak in financial health. Do your best to avoid borrowing money at all costs. One of the best advice that my mom gave to me while growing up was to never borrow money and to only use the credit card when I am certain that I’ll be able to pay it off completely by next month. Due to this, I have never been in debt with credit card companies alhamdulillah. My family and I buy what we can afford to pay in cash otherwise we don’t. It’s that simple.
None of the above is possible unless the person is willing to change his/her behavior of bad spending habits and taking the program seriously. Just like with any fitness program you need to be dedicated, disciplined, and do all the steps required to obtain the desired physique, you must dedicate yourself to the above steps in order to obtain the desired result: financial security and building wealth.
It is also important to educate our children on how to manage money and invest at an early age. In addition, we must teach them responsibility, discipline, and patience. This will help you secure their financial stability and them not having to start from zero. Just imagine how much wealth your children could accumulate if they started investing as soon as they turn 18.
Finally, as Muslims we need to understand that building wealth is not a sin. It is only wrong if that becomes the focus of your whole life and causes you to forget about the afterlife. Building wealth should not mean that we become greedy, selfish, arrogant, stingy, or try to accumulate it in impermissible ways. Some of the companions of Muhammad (pbuh) were incredibly wealthy like Abu Bakr and Uthman. The latter had so much money that he funded a whole army! As long as we stay true to our faith and look for permissible ways to build wealth, then this is a blessing from Allah and we should be grateful. Our intention should be to secure financial stability for our families and be able to give to others in charity for the pleasure of Allah. It is reported that the Prophet Muhammad (pbuh) said:
“Do not envy [anyone] except in two cases: A man whom Allah has given the knowledge of the Book [i.e. Qur’an] and he recites it during the hours of the night, and a man whom Allah has given wealth, and he spends it in charity during the night and the hours of the day” [Bukhari].
We should control wealth and it should not control us. As some of the pious Muslim sages used to say, “Keep the world in your hand and not in your heart.”