The No Debt Plan: Step Three: An Emergency Fund

by Kevin on April 10, 2008

This is the sixth post in a series: The No Debt Plan.

Today we continue along the path to financial freedom. If you’ve made it this far, you should have a budget. Thanks to that budget, you’ve also achieved free cash flow.

Let’s put that cash flow to work.

Dave Ramsey recommends readers to save up $1,000 in an emergency fund, then knock out all debt, then finish saving up to 3 to 6 months worth of expenses.

Maybe that works for you, maybe it doesn’t. Let’s define an emergency fund first.

A Proper Emergency Fund

For Emergencies Only

An emergency fund is just that — a fund of money you have saved away specifically for unexpected, emergency situations. It isn’t to be used unless you absolutely cannot cover the expense in any way. Only true emergencies count — not having enough money to buy that new cell phone does not constitute an emergency.

Easily Accessible

You need ready, easy access to this money as well. I highly recommend you get an online savings account with one of the major players. We use ING Direct and it has worked fabulously.

I do not recommend you stuff it away in a CD. CDs do earn higher interest (usually) than savings account. However, the amount of extra interest is usually nominal. Additionally, if you have to pull the money out of the CD prematurely (before it matures), you lose most or all of the interest you’ve accrued. CDs are considered a “liquid” investment, but for our purposes it is not quite liquid enough.

If you’ve got the money sitting in an online savings account, you earn interest for every day it’s in the account. Pull it out today to pay that ER visit and you don’t sacrifice the last few months worth of interest.

Still Earns a Return

Technically you could leave your emergency fund stuffed between your mattress and box spring. That would be extremely liquid, even to the point that I could steal it from you if I knew where you kept it.

The major problem with the mattress plan or anything similar — think a regular checking account that earns no interest — is the money will lose its value over time to inflation.

This is not the time for a full blown economics lesson, but here’s how inflation hurts you. You start the year off with a dollar under your mattress. The cost of living goes up 4% throughout the year. At the end of the year, you still have that wrinkled George Washington waiting in the wings. But good old George only buys you 96% of what it did the year before. Continue on for several years and that dollar isn’t worth close to a dollar.

Hopefully your emergency fund is more than a dollar. This amplifies the point. Your stash of many dollars won’t be worth as much at the end of the year. So it’s best to earn as much reasonable, safe return as you can with the emergency fund… while also keeping it liquid. That’s why ING is such a great deal. I can transfer money in and out of the account, and as it stands today, still earn 3% on my money.

Of course I’ll pay taxes on that 3% interest, so if inflation really is 4% I am still missing out. But I’m doing better than just sitting on the money at home.

How Much Do You Need Saved?

Unlike Ramsey, I’m not going to put a dollar or monthly figure next to what I think you should have for an emergency fund. Climbing out of debt is of the utmost importance, but you do need some money set aside for the inevitable moments of life.

To steal a line from JD, do what works for you. If you are comfortable with $500 as an emergency fund use that as your benchmark. If you are extremely conservative then six months may be for you. We personally target 3-6 months of expenses. Six months would be great, but it is going to take us time to get there. If you are stuck in debt, I would encourage you to save up a little and then keep plowing the rest of the money toward the debt.

What do I do?

We’re currently at about two months. The upcoming government giveaway of $1,200 ($600 + $600) will bolster this up to three months. On top of that I should be getting a bonus from work which will add another half month or so to the fund. Once we are there we’ll feel pretty comfortable. If we had an extreme emergency come up, we could cut off our Roth IRA contributions and extra mortgage payments. For now, slow and steady gets it done. We’ll build up our fund over time without jeopardizing our other goals.

How are you progressing?

As mentioned at the beginning of this article, this is the sixth post in a series called The No Debt Plan. Where do you currently sit on the plan? Have you made it to the emergency fund yet?

Pre-Steps:

Steps:

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