Earlier we have talked about the first 2 of Dave Ramsey’s baby steps.
Baby Step 1 is as quickly as possible save $1,000 starter emergency fund. It is necessary to break the cycle to always turning to debt to solve your problems. While $1,000 won’t cover every potential emergency you might face, it will cover most of them. By having that beginning emergency fund you can insure that you do not dig your hole any deeper.
Baby Step 2 is the Debt Snowball. Once you have your $1,000 emergency fund, the next step is to list all of your debts except for your mortgage. List them in order from the smallest to largest. Then attack the smallest with everything you have. Be radical. Cut back your lifestyle if necessary. Get a second job. Be weird, because normal is broke. The deeper you are willing to sacrifice the shorter the time will be when that sacrifice is required.
So now you’ve done it. You have sent the last payment in on that largest debt. You are totally, 100% debt free except for your mortgage. (We’ll get to the mortgage later.) How would that feel? Have you ever been debt free in your life?
Time to move on to Baby Step 3
Baby Step 3 is to now go back to that $1,000 emergency fund and expand it to a real emergency fund of 3-6 months worth of expenses. Some financial experts given the events of the last few years even suggest that 6 months may not be enough. Some suggest 9 months or even a year. I tend to agree with that.
It is critical that we have a sufficient emergency fund. Some people call this the rainy day fund.
According to a recent Gallup poll 68% of Americans would have to borrow money if they had an emergency of more than $5,000.
A Money Magazine article indicated that 78% of us will have a major financial event costing us $6,000-10,000 in the next 10 years.
Combine those two stats together and it doesn’t paint a pretty picture.
I think the events of the last 5 years have caused a lot of people to face the dangers of living without savings. Many people lost their jobs in the recession of 2008-2009. Many of those that kept their jobs saw a reduction in their income or at least face much uncertainty regarding their future. Recovery is occurring but much slower than many had hoped.
While hopefully we won’t face another period like 2008-2009 for a while, even in generally good times, bad things still happen to us. Unexpected home repairs, serious illnesses, major car repairs, job losses and other visits from Murphy can leave us in a major bind if we aren’t prepared. There is tremendous peace in knowing that if one of these events do occur, we have the money to cover it.
Joseph and the original emergency fund
There are many scriptures that support saving. One of the most famous though comes from the story of Joseph. Pharoah had a dream where he saw 7 fat cows and then 7 skinny cows had come and swallowed up the fat ones. Joseph was able to interpret the dream for Pharoah. Egypt was to experience 7 years of plentiful harvests, but those would be followed by 7 years of devastating famine. Joseph’s advice to Pharoah was:
Let Pharaoh appoint commissioners over the land to take a fifth of the harvest of Egypt during the seven years of abundance. They should collect all the food of these good years that are coming and store up the grain under the authority of Pharaoh, to be kept in the cities for food. This food should be held in reserve for the country, to be used during the seven years of famine that will come upon Egypt, so that the country may not be ruined by the famine.” Genesis 41:34-36
In short Joseph was telling Pharoah to build up an emergency fund.
What constitutes an emergency?
It is important to make sure you define what constitutes an emergency. I drove by the car lot and saw a really cool looking new sports car, so I need to replace my car! This is not an emergency.
I can see the road beneath me through the rust spots in my floor board so I think I need to get a new car. This might well constitute an emergency. Cars with holes in the bottom haven’t really been a good idea since the days of the Flintstones.
Make sure that you only use this fund for true emergencies. Emergencies are things that have to be addressed immediately.
Additionally, over time you should be budgeting for things like car repairs and replacement and home repairs. So when the car needs replaced, it’s not really an emergency. You know cars don’t last forever. You simply take the money you have been saving and use it to replace the car.
The longer you live a debt free life, the fewer “emergencies” you will have.
What to do with your emergency fund?
The temptation will be to want to invest your emergency fund. When you have $20,000 to $30,000 dollars, you will naturally want it somewhere that you’ll be making some money off it. Resist that temptation. Your emergency fund isn’t an investment. You want to think of it as insurance. It’s there to protect you when an emergency hits.
The problem is if an emergency hits and your “investment” is down, you’ll be tempted to borrow money to cover the emergency rather than cash out your investment when it is down. Or worse yet, you might find you don’t have enough in your emergency fund to cover the emergency.
Your emergency fund should be kept in a simple savings account. Or you might keep it in a money market account that has check writing privileges. You’ll get a little more interest in a money market account than a traditional savings account. Not as much as you would get in an investment but again, this is insurance not an investment.
You can either open an account at your local bank for your emergency fund or there are quality online banks like Ally Bank or ING Direct that are good options. I have used both and received quality service from each. The key is you want your emergency fund in an entirely separate account. This will help you to avoid using it for non-emergencies.
The beginnings of real financial peace
Emergencies happen. It’s guaranteed. If you are breathing at some point you will be faced with an unexpected emergency.
Having 3-6 months or more savings in the bank will give you peace, knowing that when Murphy comes knocking you can send him on his way. When the economy goes through another down cycle, you will sleep well knowing that you are debt free and have plenty of savings.
Jesus told a parable about a wise man who built his house on a rock. Being debt free and having an emergency fund are two of those rocks you can set your foundation upon. When the winds pick up and the storm begins to blow, and you know it will blow, your financial house will stand.
What would it feel like to be debt free and have 6 months savings in the bank? If you aren’t there what is stopping you? Post a comment and let’s discuss.