This one is easy. By this point, you have no debt payments except for maybe your house. Taking 15% off the top should be easy enough to accomplish.

The first big question is where to stash it all.

Well, if your employer offers a Roth 401(k), that’d be your best bet to get started. If you have adequate control over the investments in the account, you should look at maxxing out your contributions to the Roth 401(k) account. If you’re choices are limited, then contributing to the Roth 401(k) up to any employer match is your best bet.

If your employer does not offer the Roth version of the 401(k), you will still want to contribute into a traditional 401(k) up to the employer match. Or, if your employer offers a 403(b) or TSP, you’ll want to contribute into those programs.

After maxxing out your 401(k) or other pre-tax retirement account, you’ll want to try putting the rest into a Roth IRA. With Roth IRA accounts, you may be, depending on income limits, allowed to contribute up to $5,000 per person (as of 2008). Income limits for 2008 are up to $101,000 for single filers and $159,000 for married filers.

If, after contributing to your employer’s retirement account and Roth IRA, you are still not up to 15%, you will want to go back to your employer’s retirement account and contribute enough to get you to 15%.

For more information: There’s a great article on Wikipedia that compares the different IRA and 401(k) types: 401(k) IRA matrix.

Now that you have your accounts setup and 15% of your income going in, you need to figure out how to invest it.

Dave’s investment philosophy is quite simple:

25% into each of these four types of [mutual] funds:

• Growth
• Growth & Income
• Aggressive Growth
• International

And, to expand on what Dave says, I’m going to point you to the folks over at Merriman Berkman Next and their Merriman Model ETF Portfolios. Dave’s biggest requirement for financial advisers is that they have “the heart of a teacher.” Well, Paul Merriman and the guys fit that reqirement. They have a free weekly podcast called Sound Investing that offers great advice and learning. In addition, Merriman Berkman Next offers free educational workshops.

We’ve made it through paying off all of our debt (except for our home), now it’s time to move to Baby Step Three and fully fund our emergency fund.

There’s really not much to this step except to pile up cash into our money market account (MMA) where we kept our baby emergency fund from Baby Step One. Before moving to Baby Step Four, we need to get enough cash to cover three to six months worth of expenses not income.

If you’re on your own or just you and a spouse, you’d probably just fine to stop at three months worth. If you have a house full of kids, well then six months would make more sense.

And now we are to the meat of the plan. Baby Step Two is the Debt Snowball.

When paying off debt, there are many different ways to prioritize your debts: smallest to largest balance, smallest to largest minimum payment, largest to smallest interest rate, and so on.

The Debt Snowball is Dave’s preferred method for debt repayment. The debt snowball orders the debts from smallest balance to largest and pays them off in that order. Mathematically that doesn’t make a whole lot of sense. You know that. I know that. Dave knows that. The thing is, however, Dave has been doing this for decades. I think that we can trust his judgement on this. But, if you really want to know why he chose the mathematically inferior snowball method, it has to do with psychology more than math. By placing your smallest debts at the top of the list and paying them off first, you build psychological momentum which carries through the rest of your debt.

The Debt Avalanche is where you place your debts in order by interest rate with the higher interest debts at the top of your list. If you’re a nerd and just cannot follow the debt snowball method due to the math, the debt avalanche is your plan.

A variation of the debt snowball, called the Dead On Last Payment (DOLP) Snowball, uses a payment to balance ratio to order the debts. The P/B Ratio is the Balance Due divided by the Minimum Payment. You then order your debts by ratio from lowest to highest. In essence, this balances the snowball and avalanche methods as debts with higher interest rates will tend to have higher minimum payments and, therefore, a lower P/B Ratio.

For example, let’s look at a $5,000 loan at 6% and 12%.

6.00% – Minimum payment = $96.66. P/B Ratio = $5,000 / $96.66 = 51.7.
12.00%  – Minimum payment = $111.22. P/B Ratio = $5,000 / $111.22 = 45.0.

You can see that using the DOLP Snowball method will tend to favor paying off higher rate, smaller balance loans.

So, if you are truly unable to follow the plan laid out by Dave and the Debt Snowball, the DOLP Snowball should provide an acceptable alternative.

The only way to get out of debt is to stop going into debt. You can’t fill a hole while you’re digging out the bottom. What does this have to do with an emergency fund?

Well, let’s pretend that we’ve done our budget and now we jump straight to throwing all available cash at paying off debt. We have no emergency fund at all. Now the transmission on the car goes out and that is the only way to get the kids to school, dad to work, and groceries home from the store. You can’t go without the car. (Let’s not even talk about the state of public transportation in the U.S.) You have to get the car fixed, but $600 is too much cash to come up with on a moment’s notice. So out comes the “For Emergencies Only” credit card. The hole just got dug a bit deeper. Now we’ve fixed the car and the hot water heater decides to empty its contents into the laundry room. I don’t even know how much a new hot water heater costs nor do I know how much it will cost to repair the damage caused by the associated mini-flood. But where does that cash come from?

So what do we do? Well, if you had setup an emergency fund before starting your debt reduction plan, you could have paid cash for those emergencies rather than go further into debt.

Dave’s Baby Step One calls for $1,000 in the bank in what he calls a “Baby Emergency Fund.” A $1,000 is not enough for a real emergency fund, but while we are working to get out of debt, it will provide the short term buffer we need.

Where should this money get put? Well, it needs to be easy to get to in case of emergency, but not so easy to get to that a trip to the supermarket gets classified as an emergency when the budget for food is running low.

A great place to put this is a money market account that has check writing privileges. Bankrate.com is a great site to use to search for money market accounts based upon features, rates, locations, etc. Personally, we use GMAC Bank for our emergency fund. As of November 26, 2008, they are paying 3.2% APR on their MMAs. You can access your account online and transfer funds from your checking account into your MMA. You get checks and a check card for account access.

Once your $1,000 baby emergency fund is in place, it’s time to move onto Baby Step Two…

Dave doesn’t really include this as an official baby step, but it can, for a lot of people, be much more difficult to accomplish than any of the seven official baby steps.

The concept is simple: write down all of your income for the month and then start listing and subtracting your expenses until the bottom-line equals $0.00. This is called a zero-based budget.

The hard part comes in (1) prioritizing your expenses, (2) figuring out how much to assign to a category, and (3) handling variable or periodic incomes and expenses.

Prioritizing Expenses

Listening to Dave’s radio show, it shocks me to hear how many people pay their credit cards and luxury expenses before they pay their home mortgage! Talk about some screwed up priorities!

Dave tells people to place these five items at the top of their budget:

1. Food
2. Clothing
3. Utilities
4. Transportation
5. Housing

Until those five categories are paid, no other expenses get paid.

Funding Your Categories

Another issue is knowing how much money to assign to each category. This part takes time to get right. My wife are still adjusting our budget 5 months after starting our budgeting. The easiest thing to do is to look back through your bank records and assign your transactions to categories. From there you can cut back your spending to fit your budget.

A great web site that can help with this process is Mint.com. Once you sign up for a free account and you input your bank account information, Mint will download your transaction history and categorize your transactions for you. It also has per category budgeting functions to help keep you on target. It can even send you text message alerts when you bust a budget category.

Here’s a screenshot from the Mint.com front page showing an example of how your spending is categorized and graphed:

Handling Variable and/or Periodic Income and Expenses

Real troubles start when you have to deal with variables of income and expenses.

I’ll be honest and tell you that I’ve never had to deal with variable income, so I can’t get personal advice on that. But, if I were in your shoes, what I would try to do is to budget based upon a minimum income. If your income is never less than $2,000 per month, then try to budget with that income by funding your expense categories based upon priority. Some items at the bottom of the budget might not get funded… but at least you have food on the table and a roof over it all. If you are lucky, though, all of your categories might end up getting funded. By doing it this way, any extra income you get that month can go straight onto your debt.

Variable expenses are much easier to deal with than variable income. There are at least two types of expenses that fall into this category and they are all handled differently.

1. Monthly expenses that vary from month to month. Utility bills, fuel costs, etc. With these items, I like to budget for an annual maximum. Then at the end of the month, any cash left in that category gets dumped straight onto debt. For example, if my electric bill comes in at $350 during the hottest month of the summer, I’ll try to budget $350 per month every month. Then, in the spring and fall when the bill probably doesn’t even break $200, that’s an extra $150 per month to throw on debt!

2. Annual or quarterly expenses. Insurance payments, property taxes, annual memberships, etc. These items, with luck, are somewhat fixed or their annual increase is predictable (3% more per year, for example). The easiest and, probably, safest way to handle these is to divide them into monthly payments and set that amount aside into a savings account each month. Then, by the time the expense is due, you have the cash sitting aside ready to go. Another way to handle these, in cases where you get additional lump sums of cash (annual bonus, commissions, etc) is to set aside the full amount when a lump sum comes in. This method is a bit more risky depending on the dependability of that extra cash flow.

Back in January, my dear wife and I were talking about our finances and the amount of debt we were in. She asked me what I thought about Dave Ramsey.

Um, who?

Dave is a personal finance guru with his own radio show that is syndicated across the country and his own show on the Fox Business Network. He’s also the author of a few books on personal finance that possess the potential to change your life like they changed ours.

In The Total Money Makeover, Dave thoroughly introduces the reader to his Baby Steps:

1. Baby Emergency Fund
2. Debt Snowball
3. Fully-Funded Emergency Fund
4. Invest 15% of income
5. Kids’ College
6. Pay off home
7. Build wealth and give!

At first, I was hesitant about Dave and what a book full of common sense ideas could do for us and our $125k worth of debt. I mean, seriously! I know that we need to stop incurring debt and put more money toward paying off debt in order to fill this hole we had dug.

Well, let me tell you, this book got through to us in ways that common sense and basic math knowledge just couldn’t. We have a plan and hope now.