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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?

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Personal Finance 101 – The $1k Baby Emergency Fund

Tsh — Tue, 19 Feb 2008 21:43:15 +0000

This is the second 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.

As I mentioned a few days ago, I’m going to tackle the topic of about Dave Ramsey’s Baby Steps over the next few weeks. The concept is still a bit new to me, so a big reason I’m writing is for my personal benefit – to clarify my thoughts and convictions, to succinctly hone our plan, and to reveal any fallacies.

That said, the Baby Steps were created for the regular Jane – the person without a BS in business or finance, the person who does their taxes online (without a CPA) and wants, more than anything, to just gain control over their personal finances. That’s me.

The essential thing to understand about this financial plan is that its purpose is for you to live debt-free. That means getting out of debt and staying out of debt, for the rest of your life. No longer using debt for anything. Ever. Not school, not braces, not weddings. The only debt Ramsey’s okay with is a fixed-rate 15-year mortgage with at least a 20% down payment (although he even advocates buying real estate with 100% cash down, if you’re able). This means cutting up your credit cards. You don’t need them anymore – even “for emergencies” – if you’re on this plan. Baby Step 1 is your new plan for emergencies. Toss the cards. I’ll discuss the evils of debt in more detail on Baby Step 2. If you can’t quite give up credit cards yet, you’re not ready to move on. Stop there.

Moving right along. Baby Step Numero Uno – quickly save $1,000. Quite a few people probably already have this and then some (I’ll explain in Baby Step 2 what to do with the “then some”), and for others, this might be the most they’ll have ever saved up in their life. But the important key here is to save it up quickly. This step is not supposed to take long because you’ll lose momentum. Ramsey recommends getting a little side job, selling something on ebay or craigslist, or seriously cutting back on a spending category of yours for a short while. Step 1 should take one to two months max. Start getting ready for that garage sale.

$1,000 should feel like a rather small emergency fund – that’s because it is. Ramsey says having a smallish safety net (although it is still a safety net) helps with the urgency needed to get out of debt. $1K should be enough to cover those basic emergencies that might come up – plumbing issues at home, air conditioning servicing, gasket and zip-zorp replacement on your car (I obviously know vehicles). But the sooner you get through Baby Step #2 – getting out of debt – the sooner you get to the third step, which is fully funding your emergency fund. That will get you through more serious, potentially longer-term emergencies (such as unemployment). You want to get there as soon as you can, so hurry up and get that baby emergency fund so you can plow your way out of debt and then really save.

A caveat – and this is important – this cash is for emergencies. A new dress for the company party, a weekend away, Christmas – none of those are emergencies (it’s on December 25 every year). Unless something serious comes up, it’s almost best to forget the money is even there. Leave it alone. It’s your safety net (since you’re not using credit cards, or any other form of debt, ever again).

At the same time, keep it liquid. You’re not investing here, so the goal is not the highest possible interest rate (in other words, no mutual funds or something with penalties for early withdrawl). A solid savings account with easy access is ideal. Many Ramsey-ites keep their emergency funds at ING Direct – their savings accounts currently yield 3.40%, and you can easily connect it to an Electric Orange checking account (which, coincidentally currently yields 2.25%). This is where we have our emergency fund.

So that’s Baby Step 1 in a nutshell. It’s the easiest one to understand, so it’s pretty basic. But it’s THE foundation to the rest of a well-tested debt-free financial plan that works, so you gotta have it. Put a thousand bucks in the bank as soon as you can, and don’t touch it once it’s there.

Missed other parts of my series?

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Plan to Eat - meal planning made simple.
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Personal Finance 101 – The $1k Baby Emergency Fund is a post from Simple Mom