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Keep Your Spending Tidy With an Envelope System

Tsh — Mon, 29 Sep 2008 10:00:35 +0000

We use cash for most of our day-to-day purchases. A lot of this has to do with where we’re currently living – not as much is online, and not many mom-n-pop stores here take plastic – but even stateside, we rely a lot more on cash than on plastic. I’m not here to debate the security issues of using a debit card versus cold hard cash (maybe I’ll dip a toe in that water one day), but overall, I can positively say that using old-fashioned cash with the tried-and-true envelope system for everyday purchases works well for us.

The Benefits of Cash

• You can’t spend money you don’t have. Many bank accounts provide overdraft protection, so even with a debit card, it’s easier to go over your account balance than you think.

• You’re more aware of what you’re spending – if you’re using an envelope system, that is. Yes, it’s unbelievably easy to let cash slip through your fingers when you’re not paying attention to it. It can be slightly easier to keep track of purchases with a bank statement. But if you’re willing to keep a daily record of what you’re spending, it’s not hard to keep track of cash at all – and you save money in the process.

• It hurts more to spend cash, so you don’t spend as much. I’ve heard Dave Ramsey say this before, and I think it’s true – it’s a bit numbing to swipe your card at the store. But it’s more painful to pull out a wad of 20-dollar bills to pay for those jeans. You’re more likely to think through your purchases, and therefore, not spend money where you just don’t need to.

An Envelope System, Simplified

Here’s how we create our envelope system.

(Note: my husband receives his salary just once monthly, so we have a pretty cut-and-dry monthly budget. If you get paid every two weeks, it would probably be easier to create a workable system where you fill and spend envelopes according to your paycheck. In other words, work with your cash flow, not with a system that you think you should have.)

1. About a week before the new month, we create our next month’s budget (we use Pear Budget).

2. When our salary hits our account (and we can predict down to the hour when the money will appear), we act immediately. Basically, on payday, one of my household management tasks is our bank accounts.

3. I look at our monthly budget, and total how many of those categories we’ll spend in cash. That’s how much money we need to withdraw from our bank.

4. I leave a couple hundred in the account to serve as padding for bank and bill mistakes (and for us, we also need padding for fluctuating exchange rates). I also make sure to leave enough money for our online bills and expenses. But then, I go ahead and withdraw enough cash to fill our envelopes, right then and there.

We fill our envelopes with the cash needed for each of these categories (which we figured out when we did our monthly budget). When the cash runs out, that’s it for that category.

Photo by velo_city

Keeping Track of it All

Let’s say I need to hit up the grocery store for my regular weekly trip. I take a generous amount of cash from the grocery envelope (though not all of it), put it in my wallet, and head to the store. If I’m not replenishing an enormous amount of groceries, I keep a general till in my head as I shop; otherwise, I pencil in a rough amount on my grocery list. I usually round up, to be safe. The reason I don’t put the exact amount down to the cent is because I’m rather an idiot at math – I keep it simple so that I can total it up in my head.

Because I’ve kept track of my grocery selections, I’m confident of my estimated total as I head to the register. I pay in cash, and I immediately label the receipt “groceries” before putting it in my wallet.

When I get home, I empty my receipts and put them in our designated spot near the front door. As I mentioned in my ebook, we have a landing spot for things like keys, sunglasses, and shoes by the front door. Well, we also have a receipt dump.

Once a week, I take all our receipts, which are (hopefully) all labeled with our expense categories. I then enter them in to our Pear Budget account, complete with appropriate tags to keep track of our categories. And of course, I also enter our online expenses and income, too.

Spending Money

You might remember when I described how we create our zero-based budget that we specifically have categories designated as free spending money. It’s not much, but both my husband and I each get a set amount each month to spend on whatever – coffee is usually my purchase of choice. We put this money directly in our wallets, and we make sure to keep that separate when we have money from another envelope. When our spending money is gone, it’s gone until the next month.

A Few Answers to Predictable Questions

Q: Are they real envelopes?

Pretty much. They’re plastic zippered pencil pouches, and we keep all of them together in a basket on our desk. They’re labeled with each of our categories:

groceries – this includes anything we’d get at the grocery store, such as toiletries
household – this is different from one month to the next, but it includes things like a new bath mat, or a printer cartridge, perhaps
public transportation – metro, bus, and taxi fares (it’d be the equivalent of gas for those of you with cars)
dining out & family fun – restaurants, movie rentals, perhaps a fun treat for the kids, like a trip to the zoo

Photo by no feeling

Q: Do you carry around a ton of cash?

No. We leave our cash at home, and take it with us when we’re purposely going out to spend the money. Yes, there are times when we’re out that we need to make an unexpected purchase – but it’s not often. An envelope system curbs our impulse purchasing power, which is one of the real benefits. But when it does happen, we either use cash from another category, then adjust accordingly when we get home; or we use our debit card, and label the receipt with that category name immediately before putting it into our wallet.

Q: What about unexpected things?

Real life happens, of course, and there might be times when we need more grocery or transportation money than we thought. In that case, we juggle money around from the other envelopes. It’s good to stay flexible, but the money has to come from somewhere. As much as I’d like it, my superpower is not making money magically appear, and our family doesn’t use credit cards. It’s only logical that if we need more grocery cash, then we either need to make more money, or take it from another category.

Q: What if you spend money on more than one category at the same store?

I don’t split hairs over it – I just spend cash for one purchase, then make a note on the receipt of what was from a different category. For instance, if I bought household supplies at Target, and while I was there I bought a DVD for our family, I simply tick the DVD on the receipt as “family fun,” and enter that separately on our budget record. I’m hoping that Pear Budget will soon be able to split receipts into multiple categories, like the painfully overloaded Quicken.

I know that in this digital age, spending cash is almost considered a faux pas. That’s okay with me, though – we spend less money when we do, and that’s more important. We’ve never lost the money, and since the envelopes are only for a few spending categories, it’s not as much money around our house as you might think.

Thanks to ING Direct’s incredible ability to create umpteen jillion accounts for free, we pretty much use the envelope system for our online purchases as well. The system is called sinking funds, and we have individual online savings accounts, all with ING, labeled things like Christmas, clothing, and giving. As we spend money online from our checking account, we simply transfer the exact funds from the appropriate savings account. It’s beautifully simple, really.

Do you use cash for anything anymore? If so, do you use an envelope system to keep track of it? What’s worked for you? I’d love to hear.

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A Preschooler’s Allowance

Tsh — Fri, 16 May 2008 04:00:12 +0000

As I mentioned yesterday, we’ve started giving our three-year-old daughter an allowance in exchange for simple household chores.

Photo by Michele Catalano

I know that $2.45 weekly isn’t going to buy much more than M&Ms or a bouncy ball. But that’s not the point. The point is, we want our kids to start learning how to manage money early.

I’m a Dave Ramsey-ite, but this idea is not trademarked by him. The basic concept of giving, saving, and spending has been around for generations, and we want to keep it that way in our family. The sooner our children understand that our money is given to us by God, and that out of thankfulness, we give some of it back, the easier it will become a lifelong habit.

Saving money likewise requires discipline, and to practice the art of paying yourself first, even from the 17 nickels like we did last week, will reap benefits that far outweigh whatever could be bought with 1.7 coins.

So when we give our daughter her allowance (or commission, or whatever you want to call it), we count the stickers on her chore chart, and then count out the same amount of nickels. We then tell her how much goes into the giving jar, and how much goes into the saving jar. The rest goes into the spending jar.

Her spending money can go towards whatever she wants. That means that yes, if she’s in the grocery cart and she wants those gummy bears, she can buy them if she has enough money. But it comes out of her spending jar. (A side note: Of course we take care of her needs, and yes, we buy her gifts from time to time. Not a lot, but we aren’t expecting our three-year-old to fend for herself financially. That would be nice, though, wouldn’t it?)

We haven’t used this system long enough to really see the longer-term benefits, but friends of ours who use this method have nothing but good things to say.

There’s a guy in his mid-30s from our church back in the States who bought his family’s Suburban with 100% cash from his childhood allowance. We don’t really have those kind of expectations for her giving and spending goals, but again, the account balance is not the point. The point is cultivating a habit in preschool that’s hard for grown adults to do. Hopefully, her heart will follow.

Isn’t that a great gift to give your kids? It really is all about changing your family tree, one small thing at a time.

How do you work out money with your kids?

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Personal Finance 101 – Paying off your Home Mortgage

Tsh — Tue, 13 May 2008 04:00:56 +0000

This article is featured in the 153rd Carnival of Personal Finance, hosted by Money and Values.

This is the seventh part in my series on Dave Ramsey’s Baby Steps, a proven personal financial plan. My goal is to explain a really solid money management plan in plain ol’ English, for intelligent yet financially “average” home managers.

Photo by orvaratli

It’s now time for Baby Step #6 – pay off your house.

Dave Ramsey recommends being debt-free – as in really debt-free. Zero debt – that includes credit cards, student loans, mortgages, the whole bit. This is something most people can’t fathom, because normal in America is having debt. It’s a way of life.

If you’re debt-free except the house (Baby Step #2), you’re free to load up a fully-funded Emergency Fund (Baby Step #3). Once you have that cushion, you can then invest into retirement, an education fund, and in paying off your mortgage. And once you have that paid off, you then have the complete freedom to invest in yourself and not a bank. You can change your family tree.

Here’s the most common argument for not paying off your home early:

You get a tax deduction when you have a home mortgage.

Dave’s answer: Let’s say you pay $10,000 in interest one year, which creates that tax deduction. If you didn’t have that deduction, the $10K you kept would be taxed, and if you are in a 30 percent bracket, you would have to pay $3,000 in taxes. In keeping a mortgage around, you are essentially paying $10,000 to the bank to avoid paying $3,000 to the government.

A little side note: Another huge myth in our culture is that you have to own a home, that buying is always better than renting. True, owning a home can be a great thing, but only when you’re financially able to do so. When you buy more than you can afford – and this happens all the time, as we can see from all the sub-prime craziness as of late, that home mortgage becomes a curse and not a blessing.

We are currently renting because we live overseas, and in this particular country, the economy is too unstable to risk taking out a mortgage. But whenever we move back to the States, we plan on not buying a house until we have at least 20 percent saved up. Yes, we want to own a home – believe me, it’s a huge dream of ours. We actually want to build a home ourselves. But it truly does not seem worth it if it means chaining us down with a ridiculous mortgage that doesn’t work. Home ownership is not the answer to all of life’s financial questions. But our culture certainly preaches it these days.

I’m happy to say that I’m not the only financially-aware mom in the blogosphere that’s glad to be renting: Lynnae, Crystal, and the Millionaire Mommy Next Door are all renters, too.

Dave recommends only getting a fixed 15-year loan with 20 percent down and the payment being no more than 25% of your take-home pay. But he even advocates that you can even pay 100% cash for a home. Seriously.

If you had no mortgage, your biggest wealth-building tool – your income – would be completely freed up to really invest it where you want it. Then you get to do some pretty amazing stuff, like build more wealth in order to give like crazy. As Dave says, when you live like no one else, later you get to live like no one else.

We’re almost done with Dave Ramsey’s Baby Steps. We’ve got one more, and it’s an awesome one.

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Personal Finance 101 – Saving for your Kids’ College

Tsh — Mon, 05 May 2008 01:00:43 +0000

This is the sixth part in my series on Dave Ramsey’s Baby Steps, a proven personal financial plan. My goal is to explain a really solid money management plan in plain ol’ English, for intelligent yet financially “average” home managers.

Photo by arnoldo

O
nce you start funding 15% of your income towards retirement, and once you’ve fully funded your Emergency Fund (and any other big purchases you’re saving for – like a Car Replacement Fund), it’s time to start funding your kids’ future education.

This does not mean you can now afford to save up for the most expensive private school out there, nor does it mean your chid doesn’t need to contribute personally towards his future. But it does mean you are financially free enough to provide at least some towards a college education – at least a start towards entering university life debt-free (and hopefully staying that way).

Here are the nuts and bolts of Baby Step #5 in Dave Ramsey’s plan – put money towards your children’s college fund.

Dave’s Rules for College

These are pretty straightforward:

1. Pay cash. The average college student today graduates with about $15,000 in student loan debt after spending 3-4 years in an apartment. What a heavy weight strapped to a graduate’s shoulders fresh out in the job market! If you’re able to help your child avoid that burden, then do so.

2. And If you have the cash or the scholarship, go. As in, to college.

Student loans are so normal these days; there’s a prevailing myth that you can’t possibly go to a university without them. But they’re just not worth it. Even with the low interest rate most federal student loans have, you just never know what the future holds. I know I’d hate to corner my kids into having to pay for their education after they’ve received it. What if they’re offered some really great opportunity after graduation that pays very little (or not at all), yet is invaluable to their career or overall well-being? What if they want to settle down and become a wife and mom right away? These things would be so much harder to do with student loan debt.

Dave says this:

“If you’ve planned your savings goals and don’t have much room in the budget for college, don’t panic. Knowledge is just part of the formula to success. With what you are able to save, those precious kids can probably get a good degree if they will suffer through lifestyle adjustments and get a job while in school. Work is good for them.”

I wholeheartedly agree. I worked part-time all through college, and while I hated it at the time, I can look back and see the enormous life and business lessons I learned from those long shifts waiting tables. These life lessons are just as much a gift as the money you contribute to your kiddo’s education. Consider giving them that valuable experience.

Photo by s2photo

Where to Save the Money

Dave recommends putting college tuition funds in either an Educational Savings Account (ESA) or a 529, which are state plans and therefore different depending on your state of residence. College tuition goes up faster than regular inflation – 7 percent for college versus 4 percent for most everything else. This means that in order to keep up with tuition rates, you’ll need to earn at least 7 percent per year to keep up with the tuition increases.

With an ESA funded in a growth-stock mutual fund, your money will grow tax-free when it’s used for higher education. You can currently invest $2,000 per year, per child in an ESA (if you make under $200K a year) – and if that ESA averages 12 percent, you’ll have $126,000 in tax-free education funds by the time they’re ready for college.

If you make more than $200,000, or for some reason you want to contribute more than $2,000 a year (possibly the case if your kids are older than 8), then 529s are for you. There are lots of different 529 types out there, but Dave only recommends a “flexible” plan. He says you could pick from virtually any mutual fund in the American Funds Group or Vanguard or Fidelity and probably be okay.

Application Time

How this applies to you depends on your circumstances.

• If you don’t have kids, it doesn’t apply to you at all because you can’t open ESAs or 529s for people who don’t exist. But seeing as this is Simple Mom, I’m guessing most of my readers are parents.

• If you you’re not debt-free (Baby Step #2), you don’t have three to six month’s of expenses in savings (Baby Step #3), and you haven’t started contributing towards your retirement (Baby Step #4), then you’re not ready to start saving for your kids’ college. Under Dave Ramsey’s plan, you’d hold off contributing to your kids’ college fund until you completed the previous Baby Steps.

This makes sense – why would you save for your kids’ education and not your retirement? In doing so, you’re strapping your kids down with having to take care of their parents down the road. I’d rather not do that and have them work for part of their college funding.

• If you are at the stage of saving for your kids’ college, then Dave recommends sticking to mutual funds through an ESA or 529. And do what you can afford without feeling guilty if you can’t fully fund their education. That’s never been part of the definition of a good parent.

Photo by snowdeal

Our Personal Plan

As of now, our plan when we’re at Baby Step #5 is to provide a “matching promise” for our kids – we’ll match whatever they’re able to save, up to what an ESA allows at the time. And if they don’t have enough saved by the time they’re ready for college, we will highly encourage them to not take out student loans. They’re just not worth it.

I’ll end with another quote from Dave:

“Regardless of how you save for college, do it. Saving for college ensures that a legacy of debt is not passed down your family tree. Sadly, most people graduating from college right now are deeply in debt before they start. If you start early or save aggressively, your child will not be one of them”

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We have a winner!

Tsh — Sat, 26 Apr 2008 08:30:11 +0000

The winner of The Total Money Makeover is Karen at Simply A Musing Blog! Congrats, Karen. I hope it blesses your family and serves as an encouragement to you. (She, incidentally, also loves triple suicide chocolate cake.)

For the other 156 of you, I still highly encourage you to get it. It has been the best financial resource for our family. I’ve been writing a series called Personal Finance 101 based on Dave Ramsey and The Total Money Makeover, and it highlights all seven of his Baby Steps.

Just for fun, here are some of the more creative-sounding desserts mentioned throughout the contest:

Photo by Katy at Pomelo Pleasures

the green dessert - Marly
better than sex – Valerie (my friend Clarisa makes this, too)
claim jumpers chocolate cake – Chanelireli
extreme moose tracks ice cream - Tamara
chocolate chai pie - Wendy (I’m drooling just thinking about it! I need this recipe, Wendy…)
dies and went to heaven chocolate cake - Sue
better than robert redford cake - Adria Sha
snicker salad - Terra Heck (apples, Snickers, cream cheese, and cool whip? Who knew?)
dump cake - Christi239 (yellow cake mix, butter, pineapple, and cherry pie filling – quite the concoction!)

Well, now that I need a sugar fix, I’ll leave you for the weekend. Have a great one, and I’ll be back on Monday!

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Free Giveaway: The Total Money Makeover!

Tsh — Mon, 21 Apr 2008 08:43:53 +0000

This giveaway is now closed. Thanks for entering!

To those of you hopping over from Bloggy Giveaways – welcome to Simple Mom!

For this season’s Bloggy Giveaways, I’m giving away ONE reader one of my favorite books, The Total Money Makeover by Dave Ramsey. Since this blog is about simplifying the job of home management, I can’t help but recommend Dave’s financial philosophy, plan, and products. He can’t get much simpler when it comes to personal finance! I highly encourage you to follow his ideas for your family’s financial game plan.

Hence – I’m giving away the book.

The “fine print”:

• To enter, leave a comment at this post. In your comment, tell me your all-time favorite dessert. (And you’re crazy if it doesn’t involve chocolate.)

• Be sure your comment is linked to a valid e-mail address.

• To be entered twice, subscribe to my feed, then leave a second post telling me you’re a new subscriber.

• You have until Friday, April 25 at midnight Pacific Standard Time (U.S.) to enter.

• All entries worldwide are welcome! I’m willing to ship to my fellow non-U.S. residents.

• I’ll do a random drawing and announce the winner here on Simple Mom on Saturday morning, April 26.

If you’re new to Simple Mom, I encourage you to take a look around, contact me if you have any questions or thoughts, and subscribe via RSS or e-mail!

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My Guest Post – The Beauty of Sinking Funds

Tsh — Mon, 21 Apr 2008 06:33:15 +0000

I’ve written a guest post today over at Bible Money Matters. It’s part of my series here on Dave Ramsey’s Baby Steps. Go check it out, if you’re so inclined.

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Personal Finance 101 – Saving For Retirement

Tsh — Fri, 21 Mar 2008 21:27:03 +0000

Photo by ballycroy

It has taken me awhile to get to Baby Step #4 in my Dave Ramsey series. This is mostly because I don’t understand a lot of it. Don’t get me wrong, I understand the step:

#4 – Invest 15% of your income into retirement savings.

Understanding it – easy-peasy, Japaneezy. Knowing the best way to do it – not so much. Not by a long shot. I’m still researching it for our family, and I’m simply not at a place where I’m confident enough to write about the various methods of accomplishing this step.

I understand the importance of doing it, the why behind the what. I want to retire with my hubby where we’re not a burden to our kids. We have no desire to throw in the metaphorical towel of life and kick back in Miami, we want to bless those around us doing whatever we’re called to do, no matter our age or health. This will take money. Not a lot, hopefully, but enough.

Here’s the nuts and bolts of Dave’s advice:

What we teach is to invest 15 percent of your pre-tax income for retirement once you get to Baby Step Four. You should start with contributions to the 401(k), putting in just enough to get the company match, then max out the Roth IRA. If you get no company match, then start retirement investing with the Roth. The reason is that a Roth IRA grows tax-free and is a better option than the 401(k), which grows tax-deferred. It’s a three step process; first contribute what your 401(k) matches, then the Roth, then go back to the 401(k) and contribute until you hit 15 percent. Don’t get too enamored with the full-service investing stuff … just do basic mutual funds.

Dave is into mutual funds more than any other type of investment (except possibly real estate, but only when bought with 100% cash). He recommends only mutual funds with at least a 10-year track record of doing well, averaging around 12% (which some people out in the blogosphere balk at, saying 8-9% is more realistic). With a somewhat predictable inflation rate of about 4%, you’re ideally looking for an 8% return on an investment (12% – 4% = 8%).

Bankrate has a good calculator to help you determine your basic retirement needs. Here’s a snapshot from their site:

In this example, if you’re 30 and would like to retire at 65 with an annual income of what would be $30,000 today, with a conservative 8% rate, you’ll need to save a total of almost 2 million dollars. That would be around $132,000 invested.

Now if you’re following Dave Ramsey’s Baby Steps, you wouldn’t be on this step until you’re debt-free and have 3-6 months of living expenses in savings. So even if your company does a 401(k) match, he recommends stopping all retirement contributions until you’ve checked these steps off. That’s scary to most people, which he says is a good thing, lighting a fire under you to get the ball rolling.

We personally are not yet on Baby Step 4, so technically, we shouldn’t be contributing to retirement. But we are (shhh… don’t tell Dave). But it’s not much – 8% right now. Of course, we’ll definitely bump it up to 15% when we’re officially on this step!

Quite honestly, I don’t know much more about investing. But there are lots of good reading and resources out there, so I’ll point you in their general direction:

Here are the retirement-tagged posts over at No Credit Needed – they’ve been debt-free for a couple years, and so far, I like most of what is said over there.

Here’s a Practical Investing Guide for Beginners (that’s me!) at Being Frugal, guest-posted by Pinyo at Moolanomy.

And speaking of which, here are Moolanomy’s retirement-tagged posts. All worth reading.

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Personal Finance 101 – Sinking Funds

Tsh — Fri, 07 Mar 2008 19:07:26 +0000

As you know, our money strategy is to follow Dave Ramsey’s baby steps, and in my recent post explaining Baby Step 3, I mentioned “sinking funds.” It’s a simple financial strategy, and it’s not new, but it has enormously helped our family’s finances. And I encourage you to start using sinking funds even while paying off debt via the debt snowball.

Photo by Ironic Tonic

Simply put, sinking funds are a reserve of money set aside for some purpose. It’s a commonly used business and government practice, and it should be part of a healthy personal budget as well. If you think of your family as a company that you’ve been assigned to manage, it would only make sense to make sure you have funds readily available for the many things that surface on any given year.

Think of all those non-monthly payments or purchases you face on a regular basis. For some people, auto insurance shows up once or twice a year. What about new school clothes for your kiddos? These aren’t things you spend money on each month, but you still need to pay for them when they show up.

Nothing can screw up a debt-free plan quite like these irregular expenses. In fact, I’ll bet that’s how many people find themselves in debt.

“What? Christmas is only three weeks away? There’s no money in the budget – I guess we’ll have to whip out the Master Card.”

“Why oh why did our insurance bill arrive just when we had to pay for Sally’s recital costume? Looks like it’s Visa to the rescue again.”

If you know these irregular expenses are headed your way, it would only make sense to set aside a small portion of each budget towards them. This, in a nutshell, is sinking funds.

Christmas is an easy example. Let’s say you calculate a need of $500 for your Christmas holiday (gifts, decorations, cards, extra food – the whole shebang). It’s now March 7, about nine months away until the next season. If you didn’t start saving for Christmas 08 in January 08, that means you have nine months to complete your Christmas 08 fund – and 500 divided by 9 is $55.56. That’s how much you should list in “Christmas” as part of your regular, monthly budget.

(A side note: some people prefer to budget according to their paycheck, not just by the month. If this is you, and if you get paid biweekly, then you’ll calculate how many paychecks you anticipate from now until Christmas, and divide into that number, not the months.)

Sinking funds is an easy enough concept. But like many things in life, it’s one thing to use this method on paper; it’s quite another to put your money where your… idea… is. Sinking funds can get really fuzzy and confusing when they’re all lumped together in one savings account. Even when you keep detailed monthly records of what dollar is assigned to what, all this can rapidly become overwhelming. At least it did for me.

That’s why sinking funds didn’t work for us… until recently. Thanks to ING, we can open as many savings accounts as we want, and it doesn’t cost us a dime. We can even customize each account with a different name, and we can seamlessly automate transfers from our checking account to our various savings accounts.

We currently have five savings accounts, respectively named “Emergency Fund,” “Giving,” “Holidays & Gifts,” “Vacation,” and “Work Expenses.” Each month when our paycheck arrives, we have ING automatically transfer a set amount from our checking account into each of these accounts. Most of the money stays parked in these accounts for months at a time, until expenses arise that fit these categories.

When we need funds for these categories, we simply transfer the needed amount back into our checking account and use the amount for that expense. Very easy.

I should mention that during debt elimination, the type of sinking funds you have should be limited to the necessities. For the most part, you don’t need to focus on a family vacation or a new couch when your overarching financial goal is debt freedom. So limit sinking funds for things like quarterly and annual bills and necessities. When you’re debt-free, then you can start saving for the extra stuff.

And like I said, I think sinking funds are crucial especially during a season of debt reduction. The last thing you want to do is accrue more debt. With a Baby Emergency Fund of $1,000 and some basic sinking funds in place, it becomes so much easier to know exactly how much you can pile on your debt snowball.

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Personal Finance 101 – The Fully-Funded Emergency Fund

Tsh — Thu, 06 Mar 2008 11:55:43 +0000

This is the third part in my series on Dave Ramsey’s Baby Steps, a proven personal financial plan. My goal is to explain a really solid money management plan in plain ol’ English, for intelligent yet financially “average” home managers.

The third step with Dave Ramsey’s Total Money Makeover is to fully fund your emergency fund. This is probably the easiest step to understand, though it’s not the easiest to actually DO.

If you’re on Baby Step #3, this means you’re debt-free. And when you’re debt-free, it’s a lot easier to start spending money on the little things that really add up, be it worthwhile things like a family vacation. You write your monthly budget, and you don’t owe money to anyone, which means you see a lot more dollars on the income side. But don’t let it slip through your fingers. Pay yourself first. This will be your cushion between you and Murphy, your guarantee that you have absolutely zero excuse to ever take out debt again.

If you’ve been working the Baby Steps, and you paid off your debt using the debt snowball method, that means you can simply start putting the same amount of cash that you were giving to someone else and put it in your savings account instead. If you paid your last Visa payment in February to the tune of $500, just start redirecting that same $500 into your savings account come March. You’re already used to the same lifestyle on the same budget – just keep it up a little while longer and get that emergency fund nice and loaded.

Q: How much should I have in my Emergency Fund?

A: Take note – a fully-funded Emergency Fund should be 3-6 months of your living expenses, not your income. And it should probably be the expenses you’d deem important during a true emergency, not your everyday expenses when life is normal. Ask yourself what you’d pay when you were suddenly facing a job loss. You’re probably looking at your mortgage or rent, utilities, groceries, gas, internet service, and phone service (or just your cell phone). If you’re in the midst of a true emergency, you probably would cut out (or at least pare down) eating out, entertainment, major gift giving, and big purchases that aren’t life and death. That new dress can most likely wait until the emergency has passed.

With this info, let’s pretend using these low-end numbers:
mortgage – $800
utilities – $200
groceries – $300
gas – $150
internet service – $50
cell phone – $75
TOTAL = $1,575

$1,575 x 3 months = $4,725
$1,575 x 6 months = $9,450

With these numbers, you’re looking at somewhere between $5 to $10K. If these were my numbers, I’d play it safe and aim for an even $10,000. Remember that every household is different, so you know what’s important to you. Play with your numbers.

Q: What constitutes an emergency?
A: A job loss, major medical issues, a blown transmission, or some other unexpected event is an emergency. Christmas, prom dresses, and a weekend on the coast are not. It’s perfectly fine to save up for those things, but not in your Emergency Fund. Save for those separately, after your Emergency Fund is finished (this is called “sinking funds,” which I will write about soon).

Q: Where should I park my Emergency Fund?
A: It needs to be completely liquid, which means you need to have instant access to it. Dave says a basic savings account is fine. This is what we personally have – and we also figured we might as well get a decent interest rate while it’s sitting there. I did some research and learned about online banks – banks that have no traditional building, they only exist in cyberspace. If that sounds kinda scary, you’re not alone, but millions of people use internet banks, and since we started, we’ve never looked back.

Because they don’t have overhead fees, they can offer much higher interest rates than your standard brick-and-mortar institution. As an example, our “regular” credit union currently offers a rate of 0.69% on their savings accounts. Our internet bank currently offers 3.40% on their savings accounts – not enough to build wealth, but hey, might as well make money while we’re banking.

So where do we bank? We use ING Direct, which is renowned for its customer service. I’ve been amazed how easy it is to manage our accounts with them, so much so that it’s now our primary banking source. I highly recommend them. There are many reputable online banks – here’s a great resource for starting your research.

Q: How long will this take me?
A: It obviously depends on your interest rate and how much you can deposit monthly, but if you were able to save $1,000 in an ING savings account that earns 3.40%, you’ll reach $10,000 in nine months. Sounds like a chunk of time. It’s worth it, though. Just think – your emergency fund will be set! You can then start saving for some fun things, and except for those emergencies when you have to truly dip into that fund, you no longer have to set aside funds for a “rainy day.” You’ve already done it.

Here’s ING’s nifty little calculator to plug in your own numbers.

Missed other parts of my series?

photo credits: FastFords, redjar, Phil Moore, DJOtaku

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Personal Finance 101 – The Fully-Funded Emergency Fund is a post from Simple Mom

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