Personal finance 101 – the fully-funded emergency fund

avatar
by Tsh

Tsh is the founder of this blog and lives in Bend, Oregon with her husband and 3 kids. Her latest book is Notes From a Blue Bike, and believes a passport is one of the world's greatest textbooks.

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.

446662262_6fbfd83062.jpg

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.

snowballIf 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.
flat tire

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.

130424562_670899e71d.jpgSo where do we bank? We use Capital One 360, 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 a Capital One 360 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.

Missed other parts of my series?

photo credits: FastFords, redjar, Phil Moore, DJOtaku

Join the Conversation

Like This? Subscribe for free and have it delivered to your inbox.

Comments

  1. ARGH! Just left you the LONNNNNGGGEST COMMENT and I lost it!

    Now I’m too frustrated to try again.

    The question I had was how you got the 10,000 figure from putting 1,000 away each month for 9 months because I can’t come up with it and it has been bugging me. And then I told you about my new checking account which gets 5.5% interest. And then I talked about house debt.

    Oh well.

  2. avatar
    simplemom says:

    Hi Jodi!

    1. You continue the savings from Baby Step #1, which already has $1,000 in it. Sorry I didn’t clarify; I assumed readers could read my mind. ;) I’ll change it.

    2. Just a wild guess that paying off house debt means not getting a tax break, or that you can invest the same amount at a higher interest rate? Dave gets those questions all the time. If that isn’t what you were going to say, then nevermind, but here’s his answer:

    about investing:
    “Warren’s mortgage balance is $58,000. It’s got 11 years left on a 15-year fixed rate of 5.75 percent. He actually has the $58,000 to pay it off. Should he just pay it off or use the money for investing?

    Pay it off. Why would you keep a house mortgage? I like mutual funds, but there is this thing called risk.

    Take your old house payment and put it into mutual funds. You’ll be free in a place you didn’t know existed deep down inside. The grass feels different when the house is paid for.”

    about the tax break:
    “Alvin can pay off his mortgage. However his financial advisor is telling him not to, to invest extra funds into mutual funds and get a great tax deduction. What’s wrong with this reasoning?

    Here is what you do: fire your financial advisor! Let’s say you take out a $200,000 mortgage from the bank at 6 percent interest. Twelve thousand dollars would go to the bank in interest payments.

    Since you are in the top tax bracket, which is 35 percent, you would be able to write off $4,200 of the $12,000. In layman’s terms, your advisor is telling you to take out a mortgage and pay the bank $12,000 in interest so you can avoid sending $4,200 to the government.”

  3. No, not the tax break necessarily. As much as I would love to not have a house payment, I can’t imagine right now trying to pay EXTRA towards that goal that will help us in about 10 years or more when right now we need money for a variety of other things. I think I am much more “in the moment” with money spending which I know can not be good. But when I think about putting away extra money every month, my first thought is to save for Christmas (like you mentioned) and then a VACATION and then put the kids in things like piano lessons and perhaps a camp or two in the summer. I just can’t see putting extra money towards our mortgage at this time in our life.

  4. If I were this Warren guy, no question I would want to pay off my house if it were between that or investing.

Speak Your Mind

*