When we were in debt and needing to get control of our finances, we followed Dave Ramsey’s plan as laid out in his book, The Total Money Makeover. Dave lays out 7 Baby Steps for getting financially healthy. The first of those steps is saving $1,000 dollars for your initial baby emergency fund.
Why do you need an emergency fund? Well it’s very simple. Life happens. The plumbing suddenly gives you a fountain where you didn’t really have plans to have a fountain. Cars break down at the most inopportune times. Appliances fail. Illnesses happen. In short Murphy shows up. You know Murphy. The guy who teaches us that “Anything that can go wrong, will go wrong.”
So what typically happens when Murphy comes knocking? We pull out the credit card and say” Well, what choice do we have”. Have to get the car fixed so I can get to work. Can’t live without the water heater. Have to buy that medicine for my sick child. And deeper into debt we slip.
The idea for baby step 1 is to save that first $1,000 as quickly as you can. (If you make less than $20,000 a year then you can make your starter emergency fund $500).
One of the first keys to getting out of debt is you simply have to commit to not getting any deeper into debt. You have to stop borrowing money. If you are standing in a hole already you can’t get out by digging the hole even deeper. But as we just said, we know that Murphy shows up from time to time. We are going to have unexpected expenses. That’s just part of life.
So the answer is Baby Step 1 we save $1,000 cash and set it aside for a beginning emergency fund. Now granted $1,000 will not cover every emergency that may come up. If you lose your job for 6 months, $1,000 will not be enough to weather the storm. However, $1,000 will cover many of the common emergencies. It’ll fix the alternator on the car or replace most appliances. It’ll pay for the unexpected plumbing emergency or trip to the doctor.
With that $1,000 saved you can break the cycle of borrowing. That’s a huge step in changing your habits, and changing habits is really the biggest part of getting out of debt.
There are two important things to remember when it comes to your beginning emergency fund.
First, it is an Emergency fund. It’s not the “I’m tired, let’s eat out” fund, or the “I want to go to the game with the guys” fund or even the “Jr. grew and we need to get him some new clothes” fund. These are things that should be in the budget. The emergency fund is for true unexpected emergencies. As you make progress with the budget and over time make your way through the baby steps, you should find that what constitutes an emergency changes as well. For example, when you are just getting started the alternator going out on the car probably constitutes an emergency. But in time as you get healthier financially, you should have a car repairs item (perhaps even an envelope) in the budget. These types of repairs would just be paid out of that.
Second, your emergency fund is not an investment account. Your emergency fund is really more of an insurance policy. You aren’t trying to make money on your emergency fund. It needs to be put some place very safe and fairly easily accessible. A money market savings account is perhaps a good choice for your emergency fund. They get a little higher interest rate than a standard savings account and you can access them at any time without a penalty. You don’t want to use something like a CD because you’ll have to pay a penalty to get your money back if an emergency happens. Similarly, it’s not wise to put your emergency fund in investments. If the market is down when your emergency hits, you may find you don’t have the money you thought you did and also you’ll be tempted to just use credit because you won’t want to cash out your investment while it is down. If you knew when an emergency would hit, you wouldn’t need an emergency fund. That’s why your emergency fund is more like an insurance policy. You want it there and available when you need it.
The real key is you have to break the cycle of borrowing. The emergency fund allows you to do this. It also is the first step toward financial peace because you can rest easier knowing that when Murphy comes calling you have the cash saved to send him on his way.
Saving $1000 quickly may seem like an overwhelming task if you have not been in the habit of saving but it can be done. If you’ve already accomplished this goal post a comment with encouragement of how you did it. Later this week I’ll be posting some additional ideas of how to get started saving and keep Murphy from ruling your life.